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Chapter 07 - Cost Allocation: Departments, Joint Products, and By-Products
Chapter 7
Cost Allocation: Departments, Joint Products, and By-Products
Learning Objectives
1. Identify the strategic role and objectives of cost allocation.
2. Explain the ethical issue of cost allocation.
3. Use the three steps of departmental cost allocation.
4. Explain the problems in implementing the different departmental cost allocation methods.
5. Explain the use of cost allocation in service firms.
6. Use the three joint product costing methods.
7. Use the four by-product costing methods(appendix).
New in this Edition
Real World Focus items updated for new cost allocation issues
Revised chapter introduction
Revised exhibit on the use of Solver in Excel
New section on the decision to sell before or after additional processing
New section and new exhibit on the Constant Gross Margin Percentage method for joint
product cost allocation
Thirteen new or revised exercises and problems with a focus on strategy, ethics, and
sustainability
Teaching Suggestions
The chapter looks at the traditional issues of cost allocation among production and service departments
and where joint production processes are involved. The coverage is objective-based; it begins with strategic,
implementation, and ethical issues involved in cost allocation. The development of the procedural aspects is
comprehensive. Examples show the complete cost allocation cyclethe allocation of costs to departments, the
reallocation of costs for service departments to production departments, and the allocation to products.
When I teach this chapter, I usually spend two class meetings. In the first class I cover the objectives of
cost allocation and then I go through an example of each of the service department allocation methodsdirect,
step and reciprocal methods. Time permitting, I will go over an example of reciprocal allocation using Excel
Solver. Then, I go through a few problems for exercise. I emphasize the ethical issues and the income effects in
cost allocation. In the second day I spend a short time on joint product cost allocation, going through a problem
or two and then spend the remaining class time on a case such as one of the two cases in the case book the
Southwestern Bell case or the Brookwood Medical Center Case.
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Chapter 07 - Cost Allocation: Departments, Joint Products, and By-Products
Assignment Matrix Chapter 7
Exercises and Problems
Learning Objectives Text Features
7e 6e Transition
6e to 7e Time
Connect
1.
Strategic Role /objectives of cost allocation
2.
Ethical Issues in cost allocation
3.
Departmental cost allocation
4.
Implementation Problems
5.
Cost Allocation in Service firms
6.
Joint product costing
7.
By-products (appendix)
Strategy
Service
International
Ethics
Sustainability
Brief Exercises
7-11 7-11 5 min. X X
7-12 7-12 5 min. X X
7-13 7-13 5 min. X X
7-14 7-14 5 min. X X
7-15 7-15 5 min. X X
7-16 7-16 5 min. X X
7-17 7-17 5 min. X X
7-18 7-18 5 min. X X
7-19 7-19 5 min. X X
7-20 7-20 5 min. X X
Exercises
7-21 7-21 15 min. X
7-22 7-22 15 min. X X X
7-23 Deleted
7-23 New in 7e 15 min. X X
7-24 7-24 10 min. X X X X X
7-25 7-25 Revised 10 min. X X X X
7-26 7-26 15 min. X X X
7-27 7-27 Revised 15 min X X X X
7-28 7-28 25 min. X X X X
7-29 7-29 30 min. X X
7-30 7-30 X
7-31 7-31 10 min. X X
7-32 7-32 35 min. X X
7-33 7-33 35 min. X X X
Problems
7-34 7-34 Revised 30 min. X
7-35 7-35 Revised 30 min. X
7-36 7-36 20 min. X X
7-37 7-37 Revised 30 min. X X X
7-38 7-38 25 min. X
7-39 7-39 Revised 50 min. X X X
7-40 7-40 50 min. X X X
Continued on next page…
Assignment Matrix Chapter 7 Learning Objectives Text Features
7-2
Chapter 07 - Cost Allocation: Departments, Joint Products, and By-Products
(continued)
7e 6e
Transition
6e to 7e Time
Connect
1.
Strategic Role /objectives of cost allocation
2.
Ethical Issues in cost allocation
3.
Departmental cost allocation
4.
Implementation Problems
5.
Cost Allocation in Service firms
6.
Joint product costing
7.
By-products (appendix)
Strategy
Service
International
Ethics
Sustainability
Problems (continued)
7-41 7-41 Revised 20 min. X X X X
7-42 7-42 35 min. X
7-43 7-43 Revised 30 min. X
7-44 7-44 Revised 20 min. X X
7-45 7-45 Revised 20 min. X
7-46 7-46 50 min. X X X
7-47 7-47 Revised 40 min. X X X X X
7-48 7-48 20 min. X X
7-49 7-49 40 min. X X X X
7-50 7-50 30 min. X X
Lecture Notes
One of the most pervasive problems in management accounting is determining how the costs of a shared
facility, program, or production process should be allocated among its users. Solving this problem is called cost
allocation. Cost allocation arises in two main contexts: departmental cost allocation and joint product costing.
In allocating costs, management accountants must focus on a small number of objectives, to keep the allocation
simple and interpretable.
A. Objectives of Cost Allocation. The objectives of cost allocation are to achieve effective cost management
through methods that:
Motivate managers to exert a high level of effort to achieve the goals of top management.
Provide the right incentive for managers to make decisions that are consistent with the goals of top
management.
Fairly determine the rewards earned by the managers for their effort and skill, and for the
effectiveness of their decision-making.
To motivate managers, cost allocation can be designed to reward department managers and product managers
for reducing costs as desired. A key motivation issues is whether the allocated cost is controllable by the
manager. Providing the right incentive for decision making consistent with management’s goals is achieved
when cost allocation effectively addresses the incentives of the individual manager, including the manager’s
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Chapter 07 - Cost Allocation: Departments, Joint Products, and By-Products
relative risk aversion. Fairness is met when the cost allocation is clear, objective, and consistently applied. The
most objective basis for cost allocation exists when a cause-and-effect relationship can be determined.
However, cause-and-effect relationships are not always present; therefore, alternative concepts of fairness, such
as ability-to-bear and benefit received, must be used.
B. The Strategic and Ethical Roles of Cost Allocation. Ethical issues arise when costs are allocated for
products that are produced for both a competitive market and a public agency or government department. The
incentive in these situations is for the manufacturer, using cost allocation methods, to shift manufacturing costs
from the competitive products to the cost-plus (government) products. A second issue is the equity issue that
arises when government reimburses the costs of a private institution, or when the government provides a service
for a fee to the public. In both cases, cost allocation methods are used to determine the proper price or
reimbursement amount. A third issue is the effect of the chosen allocation method on costs of products sold to
or from foreign subsidiaries. The cost allocation method usually affects the cost of products traded
internationally and therefore the amount of taxes paid. Despite these issues, a major advantage of cost
allocation is that it draws managers’ attention to shared facilities. Furthermore, cost allocation provides a strong
incentive for individual and team efforts to manage the costs of the facilities. Finally, cost allocation can have
the benefit of reminding managers of the service and thereby encouraging them to use it.
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Chapter 07 - Cost Allocation: Departments, Joint Products, and By-Products
C. Service and Production Department Cost Allocation. Overhead costs are incurred in service
departments (HR, maintenance, engineering, etc.) as well as production departments. There are
three phases to the department cost allocation approach:
We assume here that costs directly traceable to a department are charged directly to that department. A cost can
be traced when there is a clear cause-and-effect relationship between the cost and the cost object.
Chapter 4 illustrated how overhead costs could be allocated to products in a single step, using a single overhead
pool and single overhead rate, using what we called the volume-based approach. Chapter 4 then showed an
enhancement of the-volume based approach in which overhead was allocated to products in two steps, first to
departments and then to products, in what we called the departmental approach. The departmental approach is
an improvement over the single step volume-based approach because it takes into account differences in costs
incurred in the different departments and difference in consumption of the departments’ resources by the
products, thus leading to more accurate product costs. The activity-based approach, explained in chapter 5,
follows a two-step approach like the departmental approach, with the difference that it assigns costs at a much
more detailed level, that of the operating activity rather than the department. Because of the greater level of
detail, the activity-based approach captures more accurately the consumption of the usage of resources by the
different products, and therefore more accurate product costs. Because of the increased accuracy, the activity-
based approach is generally preferred. However, there are situations where the activity-based approach is not
preferred, as when the company has homogeneous products and processes and then the departmental approach is
preferred because it is simpler, less costly, and produces results comparable the activity-based approach. Also,
there are some organizations that are required by law or regulation to use the departmental approach for cost
reporting and cost reimbursement; a health care provider affected by the U.S. Medicare law is one such
example.
The Departmental Approach is Explained in Chapter 7, as follows.
1. First Phase: Initial Allocation to Departments. The first phase in departmental cost allocation has two
parts: to trace the direct manufacturing costs in a plant to each service and production department that used
them, and to identify the indirect manufacturing costs in the plant and allocate them to each of the service and
production departments.
2. Second Phase: Allocation of Service Department Costs to Production Departments. The second phase
allocates costs from the service departments to the production departments. This is the most complex of the
allocation phases because services flow back and forth between service departments. Often these are call
reciprocal flows. Accountants use three common methods to allocate costs when there are reciprocal flows:
a. The direct method. The direct method is the simplest of the three methods because it ignores the
reciprocal flows. The cost allocation is done by using the service flows only to production departments and
determining each production department’s share of that service.
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Chapter 07 - Cost Allocation: Departments, Joint Products, and By-Products
b. The step method. The second method for allocating service costs is the step method, so-called because it
uses a sequence of steps in the allocation of service department costs. In the first step, one of the service
departments is selected to be allocated fully, that is, to the other service department as well as to each of the
production departments. The second service department is allocated only to the production departments in
the same manner as the direct method. This method is more accurate because one of the reciprocal flows is
taken into account.
c. The reciprocal method. The reciprocal method takes into account all the reciprocal flows. This
accomplished by using simultaneous equations; the reciprocal flows are simultaneously determined in a
system of equations. Each service department has an equation to represent the cost to be allocated,
consisting of the first-phase allocation costs plus the cost allocated from the other department:
Allocated S1 costs = Initial allocation + Costs allocated from S2
Allocated S2 costs = Initial allocation + Costs allocated from S1
D. Joint Product Cost Allocation. Joint products are products from the same production process that have
relatively the same sales value. The split off point is the point in the production process at which the joint
products become separately identifiable. The “joint” cost for the production of the joint products is
allocated in three commonly used methods: the physical unit method, the sales value method and the net
realizable value method.
1. The physical unit method allocates the joint cost on the basis of the proportion of the
number of physical units of output for each joint product;
2. The sales value method allocates joint costs in proportion to the total sales value of each
product at the split off point; this method tends to result in similar gross margins for
each product, in contrast to the physical unit method which does not take into account
the sales value of each product
3. The net realizable value (NRV) method is used when there is no sales value at the split
off point. Here the sales value at the split off point is approximated by the “net
realizable value,” the ultimate sales value less the additional processing costs beyond
the split off point.
4. The constant gross margin percentage method When separable costs are significant and
an important goal of the allocation is to achieve an allocation that results in the same
gross margin percentage for all joint products, then a variation of the NRV method is
used. The constant gross margin percentage method determines an allocation of joint
cost so that, after allocation, all joint products have the same gross margin percentage.
E. By Product Cost Allocation (Appendix). A by product is a joint product that has a low sales value relative
to the other joint products. For this reason the cost of the by product is determined in a different manner from
the joint products. Specifically, there are two approaches to accounting for the by-product (1) include it in net
income as “other income” at either the time the by-product is sold or when the by-product is produced (in the
latter case, net income is determined from the product’s net realizable value), or (2) recognize it is as a
reduction in the cost of the main products (i.e., the other joint products) and show it as having it’s own
inventory value, either at the time of sale or the time of production , based on the by-product’s net realizable
value.
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