2023 Module 6 Complete

COST ALLOCATION
AND
PERFORMANCE
MEASURES
THREE
ALLOCATION
METHODS
Kaplan & Atkinson Chapter 3 (66-71)
Example
Service department: Electricity Other examples:

utilities, maintenance,
(selling division)
purchasing, etc.
Operating department 1 Operating department 2 Operating department 3 Other examples:

manufacturing, assembly,
(buying division) (buying division) (buying division)
distribution, etc.
Page 3
Three allocation methods
 Kaplan & Atkinson (Chapter 3, pp. 66-71) compare the allocation of service
department costs (= transfer price) using three methods
 Standard Average Cost (SAC)
 the rate for cost allocation is defined ex-ante based on budget (standard costs/consumption). Costs
are then allocated based on actual consumption.
 Actual Average Cost (ACC)
 the rate for cost allocation is defined ex-post based on actual consumptions and actual costs
 Flexible budget for short-run control of operating expenses
 The departments are charged a fixed percentage of the service department’s fixed costs (based on
practical or normal capacity). Variable costs are allocated based on actual consumption. Practically it
is a two step allocation:
 Step 1: Allocation of variable costs at standard rate for actual consumption
 Step 2: Allocation of an annual fixed fee based on committed resources and practical activity
Service department (electricity provider)
Example
Fixed costs (committed resources) $10.200
Standard variable cost $0,02/kWh (for production levels of ± 25% of normal activity level)
Normal activity level (forecasted) 170.000 kWh
Standard cost (tot.) $13.600 (calc: 10.200 + 0,02*170.000)
Actual activity level 137,000 kWh
Actual cost $ 13,152
Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Practical capacity (kWh) 70.000 100.000 30.000 200.000
Normal activity (kWh) 60.000 85.000 25.000 170.000
Actual activity (kWh) 60.000 50.000 27.000 137.000
Std kWh for actual 55.000 50.000 28.000 133.000
output
This example is taken from Kaplan and Atkinson, Chapter 3
Page 5
Standard Average Cost
What is the standard rate to allocate energy consumption in the operating department? How are the
expenses charged to the operating departments? Discuss pros and cons of this allocation method
Actual activity level 137.000 kWh
Actual cost $ 13.152

Std kWh for actual output 55.000 50.000 28.000 133.000
Page 6
Standard Average Cost
Total allocated costs = $10.960. Underabsorption of 2.192 (13.152-10.960)
Normal activity level (forecasted) 170.000 kWh 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑𝑐𝑜𝑠𝑡
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑟𝑎𝑡𝑒= =$ 0 , 08/ 𝑘𝑊h
Standard cost (tot.) 𝑛𝑜𝑟𝑚𝑎𝑙𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙
$13.600 (calc: 10.200 + 0,02*170.000)

Actual activity (kWh) 60.000
60.000∗0,08=$4.800 50.000
50.000∗0,08=$4.000 27.000 27.000∗0,08=$2.160137.000
Page 7
Standard Average Cost and Variance analysis
 Unabsorbed costs signal an unfavorable variance of $2.192 compared to budget. Who
is responsible?
 To answer, we can separate the spending variance (controllable by the service
department) from the volume variance (controllable by the operating departments)
 To calculate the volume variance, create a flexible budget – what should the budget
be if we take into account the actual volume
 Flexible budget for actual volume: fixed costs (10.200) + variable costs (0,02x137.000) = 12.940
 Volume variance: $12.940 - $10.960 = - $1.980 (mostly caused by department 2,
which demanded 35,000 kWh less than budgeted)
 Spending variance: 13.152 – 12.940 = $212 (caused by the utility department
spending more money than allowed at the specific output level)
Page 8
Actual Average Cost
What is the actual rate to allocate energy consumption in the operating department? How are the
expenses charged to the operating departments? Discuss the results.

Page 9
Actual Average Cost
Total allocated costs = $13.152 (complete absorption per definition)
Actual activity level 137.000 kWh 𝑎𝑐𝑡𝑢𝑎𝑙 𝑐𝑜𝑠𝑡
𝐴𝑐𝑡𝑢𝑎𝑙 𝑟𝑎𝑡𝑒= =$ 0,096/ 𝑘𝑊h
Actual cost $ 13.152 𝑎𝑐𝑡𝑢𝑎𝑙 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙

60.000∗0,096=$5.760 50.000
50.000∗0,096=$4.800 27.000 27.000∗0,096=$2.592137.000
Page 10
Flexible budget for short-run control of operating
expenses
How are expenses allocated in the two steps? How are the expenses charged to the operating
departments? Discuss the results.

Page 11
expenses
1 step: Allocation of variable costs at standard rate for actual consumption
st

Standard variable cost 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑𝑟𝑎𝑡𝑒=𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒
$0,02/kWh (for production levels of ± 25% of normal𝑐𝑜𝑠𝑡=$ level)𝑘𝑊h
activity0,02/

60,000∗0,02=$120 50.000
50,000∗0,02=$1000 27.000 27,000∗0,02=$540137.000
Page 12
expenses
2 step: Allocation of an annual fixed fee based on committed resources and practical (or normal) activity
nd

Fixed costs (committed resources) $10.200 𝑐𝑜𝑚𝑚𝑖𝑡𝑡𝑒𝑑𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠
𝑝𝑙𝑎𝑛𝑛𝑒𝑑𝑟𝑎𝑡𝑒= =$ 0,051 /𝑘𝑊h
Standard variable cost 𝑝𝑟𝑎𝑐𝑡𝑖𝑐𝑎𝑙𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦
$0,02/kWh (for production levels of ± 25% of normal activity level)

Practical capacity (kWh) 70.000
70.000∗0,051=$3.570 100.000
100.000∗0,051=$5.100 30.000 30.000∗0,051=$1.530200.000
Page 13
Summary
Normal Actual Standard Average Actual Average Flex. Bgt. For short-
activity activity Cost allocation Cost allocation run control of op.
($0,08/kWh) ($0,096/kWh) expenses (based on
practical capacity)
Operating dept. 1 60,000 kWh 60,000 kWh 4,800 5,760 4,770
Total 170,000 kWh 137,000 kWh 10,960 13,152 12,940
Service dept 170,000 kWh 137,000 kWh Unabsorbed costs Full absorption Unabsorbed costs
(budget (actual for 2,192 of which for 212 (=spending
$13,600) $13,152) spending variance variance)
212
Page 14
Evaluation of SAC and AAC
Congruency
 Congruency of a cost allocation depends on how well it approximates the opportunity

costs of the service provided (i.e. the net value foregone by producing and transferring
one additional kWh).
 The standard rate is computed on the basis of the expected utilization. If expected utilization is far
below the capacity, the rate will be upward biased (higher than the opportunity cost)
 Buying division will buy less units than optimal
 The actual rate is computed on the basis of the actual utilization. If actual utilization is far below the
capacity, the rate will be upward biased (higher than the opportunity cost)
 Buying division will buy less units than optimal
 In both cases, if the service division has excess capacity, allocating costs will tend to
overstate the opportunity costs of the service provided
 buying divisions will buy less units, and excess capacity will increases even more (it can lead to a death
spiral)
Page 15
Evaluation of SAC and AAC
Controllability
Standard average cost:

 The standard rate depends on other operating departments’ expected utilization
(non-insulating allocation scheme). However, after the standard rate is calculated,
managers can control costs by deciding on the consumption level.
 The standard rate insulates operating departments from inefficiencies in the service
department (spending and volume variance can be separated). However, it is unclear
how the responsibility for volume variance is assigned
Actual average cost:
 The actual rate depends on other departments’ actual utilization (non-insulating
allocation scheme): allocated costs are neither controllable ex-ante nor ex-post).
 Inefficiencies in the service department (spending variance) affect the allocation rate.
Page 16
expenses
Rationale:
 The long-term costs of the service department should be paid by the users (operating departments
should be held accountable for the excess capacity, when it is due to their “poor” planning)
 The evaluation of the service department should not be affected by unanticipated fluctuations in the
quantity of service demanded
 The level of activity and inefficiency in any single department should not affect the evaluation of the
other departments (insulating method)
 The inefficiencies of the service department should not be transferred to the operating departments
 The operating departments should use the service available (as long as incremental benefit > marginal
cost of supplying the service)
Page 17
expenses
Advantages:
 It is more congruent because it includes a component related to long-term capacity costs
 It increase the controllability for both the service department and operating departments
 Creates good planning discipline
 A too large estimation of capacity, results in a large fee
 A too little estimation of capacity, results in no available capacity.
 Allow departments to trade with each other if reallocations is necessary
Page 18
How much does an opera cost?
 In this case study, you will help the general

manager of a prestigious Italian opera house
to make the right decisions regarding opera
production. The crucial task is the correct
costing of the opera productions, which
involves allocation of indirect costs.
 In addition to accounting knowledge, a certain
artistic sensitivity is needed to meet both the
financial goals and the cultural and artistic
objectives of the opera house.
19
 Read Part II of the case study

 What kind of allocation base would you
suggest the general managers use for cost
allocation? Why?
 Would you suggest that the General Manager
put on La Traviata? Would you suggest that
the General Manager put on Simon
Boccanegra?”
20
 Read Part III of the case study.

 Explain to the General Manager why the
current cost allocation incentivizes all
opera production managers to reduce
the number of rehearsal days and what
could happen
 Propose a solution to the death spiral
problem
21
 Read Part IV of the case study

 Explain to the General Manager why this
joint cost allocation is imprecise and
help him make the right decision
regarding Otello
22
Instructions
 Work in groups (4-5 people). Use Excel for the calculations.
 Prepare a slideshow with your advice/solutions to the problems identified in part II, III
and IV. Upload it on CANVAS
 Be ready to present your solutions in class.
 Time: 45 minutes
 Back in class at …
Page 23
Preventing the death spiral
1) Avoid allocating all fixed Do not allocate the fixed costs associated to the
building (depreciation, maintenance, utilities)
indirect costs (e.g.
depreciation) when there
is excess capacity.
These are “sunk costs” (costs
already incurred that cannot
be modified with future
decisions)
But in this case, the use of capacity (the rehearsal rooms)
would appear "free" to the opera production managers
Page 24
who would be incentivized to overuse it.
Preventing the death spiral
2) Use the predetermined Days in a year 365

-Holidays 25
practical capacity as allocation -Weekly day off 51
-Half day during performance night 80
base = available days for rehearsals 209 (all.base)
(practical capacity)
Practical capacity represents the

Each opera production manager can
amount of capacity the common choose whether to spend more on
resource was expected to provide when rehearsals or on external artists, but
it was purchased and used under their decisions would not affect other
opera production managers' budgets.
normal operating circumstances (Note that if less rehearsal days are
used, some costs remain not
allocated)
Page 25
Decide the number of rehearsal days
centrally (general manager/artistic
Preventing the death spiral (1) director) based on capacity, complexity of
the opera, and strategic/cultural relevance
of the opera.
3) Centralize decisions on the

use of the common resource
Page 26
Joint Cost
in the Opera House
 dropping Otello would make it worse!
 dropping Otello does not make the

opera house saving the fixed fee for
the shared artists: the joint cost is a
sunk cost!
Page 27
Problems with allocation of joint cost
Key takeaways
 The allocation of joint cost can cause a death spiral

 The joint cost is a sunk cost with respect to further processing of the joint product
 This form of cost allocation (insulating method) distorts the profitability of the joint
products and may lead to wrong decisions!
Page 28
How to allocate joint costs
Use Net Realizable Value (NRV) as allocation base (non-insulating method)
 NRV is the difference between selling price and costs that would be incurred after the
split-off point (similar to contribution margin).
 Joint cost allocation using NRV does not distort the profitability of the products
 (see example of the chicken processor in the textbook)
 However it does not work in non-profit organizations (where it is legitimate that
some products/projects have a negative NRV)
In the opera house example, it would be better not to allocate the joint cost at all to
avoid making the wrong decision.
Page 29

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COST ALLOCATION

Service department: Electricity Other examples:

Operating department 1 Operating department 2 Operating department 3 Other examples:

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

This example is taken from Kaplan and Atkinson, Chapter 3

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Service department (electricity provider)

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Service department (electricity provider)

Operating dept. 1 Operating dept. 2 Operating dept. 3 Total

Operating dept. 2 85,000 kWh 50,000 kWh 4,000 4,800 6,100

Operating dept. 3 25,000 kWh 27,000 kWh 2,160 2,592 2,070

Total 170,000 kWh 137,000 kWh 10,960 13,152 12,940

 Congruency of a cost allocation depends on how well it approximates the opportunity

Standard average cost:

 In this case study, you will help the general

 Read Part II of the case study

 Read Part III of the case study.

 Read Part IV of the case study

2) Use the predetermined Days in a year 365

Practical capacity represents the

3) Centralize decisions on the

 dropping Otello would make it worse!

 dropping Otello does not make the

 The allocation of joint cost can cause a death spiral

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