Cost and Revenue Allocations

EMBA 5412 Fall 2010

Introduction
 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

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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?

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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

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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

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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

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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.
 Cost allocation is viewed as a
“reasonable” or “fair” means of
establishing a selling price in the
minds of the contracting parties.
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Criteria
 Ability to bear: This criterion advocates
allocating costs in proportion to the cost
object’s ability to bear them.
 An example is the allocation of corporate
executive salaries on the basis of division
operating income.

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

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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

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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

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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 cost-
allocation base

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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

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

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

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

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Direct Method
Support Departments Production Departments

Information Systems

Manufacturing

Packaging

Accounting

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Service Allocation: Direct
Method
 Procedure:
 Ignore each service department’s use of other service
departments.
 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.

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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

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Step-Down Method
Support Departments Production Departments

Information Systems

Manufacturing

Packaging

Accounting

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Service Allocation: Step-down
Method
 Procedure:
 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.
 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:
 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

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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

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Reciprocal Method
Support Departments Production Departments

Information Systems

Manufacturing

Packaging

Accounting

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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 “managing” cost allocations for
financial reporting and/or taxes.

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

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 Example
DATA Support Depts Operating Depts
Plant Information
Maintenance Systems Machining Assembly Total
Budgeted Manufacturing
Overhead Cost before
allocations (TL) 600.000 116.000 400.000 200.000 1.316.000
Support work provided:
By Plant Maintenance
Budgeted Labor hours 1600 2400 4000 8.000
Percentage 20% 30% 50% 100%
By Information Systems
Budgeted Computer hours 200 1600 200 2.000
Percentage 10% 80% 10% 100%

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Direct Method
Budgeted Budgeted
Cost Cost Operating Depts
Support Departments Machining Assembly Total
Budgeted Manufacturing
Overhead Cost before
allocations 600.000 116.000 400.000 200.000 1.316.000
Plant Maintenance
2400 / 4000/
Labor Hours (2400+4000) (2400+4000)
Percentage 0,375 0,625
Allocated Plant Main Cost (600.000) 225.000 375.000 600.000

Information System
1600/ 200/
Computer Hours (1600+200) (1600+200)
Percentage 0,889 0,111
Allocated Info System Cost (116.000) 103.111 12.889 116.000

Total Budgeted Overhead 728.111 587.889 1.316.000

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Step-down method
 Two service depts;
 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

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 step-down with plant maintenance
first
Budgeted Budgeted
Cost Cost Operating Depts
Support Departments Machining Assembly Total
Budgeted Manufacturing
Overhead Cost before
allocations 600.000 116.000 400.000 200.000 1.316.000
Plant Maintenance
Labor Hours 1600 2400 4000 8.000
Percentage 20% 30% 50% 100%
Allocated Plant Main Cost (600.000) 120.000 180.000 300.000 600.000

Information System
1600/ 200/
Computer Hours (1600+200) (1600+200)
Percentage 0,889 0,111
Allocated Info Sys Cost (236.000) 209.778 26.222 236.000

Total Budgeted Overhead 789.778 526.222 1.316.000

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 step-down with information system
first
Budgeted Budgeted
Cost Cost Operating Depts
Support Departments INFO SYS PLANT Machining Assembly Total
Budgeted Manufacturing
Overhead Cost before
allocations 116.000 600.000 400.000 200.000 1.316.000
Information System
Computer Hours 200 1600 200 2.000
Percentage 10% 80% 10% 100%
Allocated Info Sys Cost (116.000) 11.600 92.800 11.600 116.000
Plant Maintenance

2400 / 4000/
Labor Hours (2400+4000) (2400+4000)
Percentage 38% 63% 100%
Allocated Plant Main Cost 611.600 229.350 382.250 611.600

Total Budgeted Overhead 722.150 593.850 1.316.000

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Comparison of Methods
Step down Step down
Plant Main Info Sys
Direct first first
Machining 728.111 789.778 722.150
Assembly 587.889 526.222 593.850
Total 1.316.000 1.316.000 1.316.000

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 Reciprocal computation
[A]= Plant 0 0,1
Info 0,2 0

[I] = 1 0 cost [C] = Plant 600.000

Info 116.000
0 1
multiply [I- A] inverse x [C] = 624.082
[I- A]= 1,00 -0,10
240.816
-0,20 1,00

det [I-A] = 0,98

1/ det[I-A] = [I-A] inverse 1,02 0,102

0,204 1,0204

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 Reciprocal allocation
Budgeted Budgeted
Cost Cost Operating Depts
Support Departments Plant Info Sys Machining Assembly Total
Budgeted Manufacturing
Overhead Cost before
allocations 600.000 116.000 400.000 200.000 1.316.000
Allocation of Plant Maintenance
Percentage 20% 30% 50% 100%
Amount (624.082) 124.816 187.224 312.041
Allocation of Information System
Percentage 10% 80% 10% 100%
Amount 24.082 (240.816) 192.653 24.082
Total budgeted overhead for operating departments 779.878 536.122 1.316.000

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Comparison
Step down Step down
Plant Main Info Sys
Direct first first Reciprocal
Machining 728.111 789.778 722.150 779.878
Assembly 587.889 526.222 593.850 536.122
Total 1.316.000 1.316.000 1.316.000 1.316.000

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35
Service Department Cost Allocation
assuming separate fixed and variable costs

Example
 Dual rates are used

 Distributed in class

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Allocating Common Costs
 Common Cost – the cost of operating
a facility, activity, 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

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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 cost-
allocation weights
 Individual costs are added together
and allocation percentages are
calculated from the whole, and
applied to the common cost
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Example – Common costs
 The manager of your plants in Russia wanted to
consult you and wanted you to visit their sites.Below
are the possible fares for these trips individually or
combined. You will charge the cost of your plane
ticket to these two sites.
 Dubna and St.Petersburg
 Ankara-Dubna-Ankara costs TL 800
 Ankara-St.Peterburg-Ankara costs TL 1300
 Ankara-Dubna-St.Peterburg-Ankara costs TL 1900
 How would you allocate the cost between these two
sites?

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Example common costs – stand
alone
Determine weights:
800
Dubna =  38.1%
800  1300

St.Peterburg = 1300
 61.9%
800  1300
Then costs are
Dubna 38.1% *1900= 723.90
St.Peterburg 69.1% *1900 =1176.10

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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

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Example common cost
 Assuming Dubna plant is the first
user
 Dubna gets 800 TL; St.Peterburg gets
1900 – 800 = 1100 TL
 Assuming St.Peterburg is the first
 St.Peterburg gets 1300 TL; Dubna gets
1900 – 1300 = 600 TL
Probably have to agree with the
management.
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Cost Allocations and Government
Contracting
 two main ways:
1. 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. In some
cases, the contract will state that the
reimbursement amount is based on
actual allowable costs plus a fixed fee
(cost-plus contract)

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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, 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.

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Death Spiral Example: Cost-
based Contracts
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.
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Joint cost allocation
 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

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

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Joint costs- example

Yogurt
Split off
point

Process
Raw
Pasteurize further
MILK MILK

White Cheese
Sell as MILK

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Joint costs example
 In June 2008, Bizim Sut processes 220,000 lt of raw milk.
During processing until the split off point 10,000 lt are lost
due to evaporation, spillage,etc.
 After the split off point, the may be processed further to
yogurt or cheese that share a second common processing
which costs 200.000 TL .
 Price of milk: 1.50 TL per lt
 Price of Yogurt 3.50 TL per kg; further processing cost 0.60
TL per kg
 Price of cheese 7 TL per kg further processing cost 2 TL per
kg
 Joint cost of processing raw milk 100.000 TL
 The company decides to sell half of pasteurized milk as is;
and process the rest yielding 75,000 kg yogurt and 25,000
cheese losing 5,000 lt more during the process.

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Joint cost example
JOINT COST 1 Milk Yogurt and Cheese
Sales value at split off
amount (lt,kg) 105.000 105.000 210.000
sales price (lt, kg) 1,50 4,00
Total Sales value 157.500 420.000
Weights of sales value 50,0% 50,0%
JOINT COST 1 Allocation (100.000) 50.000 50.000

joint cost 1 per lt or kg 0,48 0,48

Based on physical units

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 Joint costs example
JOINT COST 2 Yogurt Cheese
Sales value at split off
amount (lt,kg) 75.000 25.000
sales price (lt, kg) 3,50 7,00
Total Sales value 262.500 175.000 437.500
Weights of sales value 60,00% 40,00%
JOINT COST 2 Allocation (200.000) 120.000 80.000

joint cost 1 per lt or kg 1,60 3,20

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 Joint costs example
Using NRV
JOINT COST 2 Yogurt Cheese
Sales value at split off
amount (lt,kg) 75.000 25.000
sales price (lt, kg) 3,50 7,00
Total Sales value 262.500 175.000 437.500
Separable Costs per kg 0,60 2,00
Less Separable Costs 45.000 50.000
Net Realizable Value at Split-off 217.500 125.000 342.500

Weights of sales value 63,50% 36,50%

JOINT COST 2 Allocation (200.000) 127.007 72.993

joint cost 1 per kg 1,69 2,92

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 Joint costs comparison

Yogurt Cheese
TOTAL COST per kg sales value 2,68 5,68
NRV 2,77 5,40

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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 “stand-alone” prices

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Methods to Allocate Revenue to
Bundled Products
 Stand-Alone (separate) Revenue
Allocation Method uses product-
specific information on the products
in the bundle as weights for
allocating the bundled revenues to
the individual products. Three types
of weights may be used:
1. Selling Prices
2. Unit Costs
3. Physical Units
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Example
 Cybersoft produces and sells three software
programs: Writeperfect; Computeperfect; and
Graphperfect.
 Cybersoft sells these products individually as well as
bundled products.
Manufacturing Cost
Selling Price per Unit
Individually TL TL
Writeperfect 125 18
Computeperfect 150 20
Graphperfect 225 25
Bundled:
Write and Compute 220
Write and Graph 280
Compute and Graph 305
Write, Compute and Graph 380

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 Example
Individual Revenue Allocation

Use Selling Prices weights and prices

total
individual bundle
prices price write compute graph
write and compute 275 220 0,45 0,55
prices of individual products 100,00 120,00

write and graph 350 280 0,36 0,64

prices of individual products 100,00 180,00

compute and graph 375 305 0,40 0,60

122,00 183,00

write, compute and graph 500 380 0,25 0,30 0,45

95,00 114,00 171,00
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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,
etc.
 If the bundled price is more than the individual price of the
primary product, the primary product is allocated its regular
price; and then the secondary product gets its regular price;
and so forth
 If the bundled price is less than or equal to the individual
price of the primary product, the primary product is
allocated 100% of revenue; and the others in the same
bundle receive no allocation

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Example
Incremental Revenue Allocation Method

let's assume the following rank: Write Graph Compute

Cumulative
Bundle Revenue Revenue
Product Bundle Price Allocated Allocated
Writeperfect Write and Compute 220
Write 125 125
Compute 95 220

Write and Graph 280

Write 125 125
Graph 155 280

Computeperfect Compute and Graph 305

Graphperfect Compute 150 150
Graph 155 305

write,compute and
graph 380
Write 125 125
Compute 150 275
Graph 105 380
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 Example-Shapley allocation
Order Revenues Allocated to each product
First Second
Primary incremental Incremental Write Compute Graph
Write Compute Graph 125 95 160
(220-125) (380-220)
Write Graph Compute 125 100 155
(380-280) (280-125)
Compute Write Graph 70 150 160
(220-150) (380-220)
Compute Graph Write 75 150 155
(380-305) (305-150)
Graph Write Compute 55 100 225
(280-225) (380-280)
Graph Compute Write 75 80 225
(380-305) (305-225)

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 Example-Shapley value
Order Revenues Allocated to each product
First Second
Primary incremental Incremental Write Compute Graph
Write Compute Graph 125 95 160
Write Graph Compute 125 100 155
Compute Write Graph 70 150 160
Compute Graph Write 75 150 155
Graph Write Compute 55 100 225
Graph Compute Write 75 80 225

average price=Shapley value 87,5 112,5 180

Assume equal weights on all products.

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