Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
7-1
Chapter 7
Cost Allocation: Departments, Joint Products, and By-Products
Teaching Notes for Cases
7-1. Revenue Allocation; Utility Industry; Strategy
This case concerns the process used in the state of Texas to subsidize companies in the heavily
regulated telecommunications industry so that the historical goal of providing universal telephone service
at reasonable rates may be achieved in the state. The subsidization of local service, particularly in high
cost rural areas, by long distance and other more profitable services, is a cornerstone of telephone
regulation. Prior to its 1984 breakup, AT&T made enough profit from the long distance market it
dominated to subsidize local service throughout the country. Since divestiture of the seven regional
telephone companies, local exchange carriers (LECs) in Texas have been subsidized by not only
interexchange carriers (IXCs) such as AT&T, MCI, and Sprint but also by the state’s largest LEC,
Southwestern Bell Telephone Company (SWBT).
The Texas Public Utilities Commission (PUC) sets telephone rates for individual LECs based on
projections of revenues needed by them to earn target rates of return. These rates are functions of
investment community requirements. In addition to settlement payments from SWBT, LECs receive
access payments from other carriers for use of their facilities in the completion of calls. They also earn
revenues from intraLATA roll calls and local telephone service.
When a telephone company predicts its revenues will be insufficient to achieve its allowable rate
of return, it may petition the PUC for a rate increase. The commission then must decide how much
additional revenue, if any, to allow the company, and from what category(s) of service. If, for example,
the PUC decides to allow an LEC to bill its customers an additional $100,000 for local telephone service,
it will adjust the company’s rate structure to provide the increase. Due to the size of SWBT (it has
approximately 80% of the telephones in Texas), its intraLATA toll rates are assigned to all local exchange
carriers in the state; consequently, a toll rate increase granted to SWBT improves the earnings and rates of
return of all 59 companies.
The PUC monitors the earnings of LECs. It may take action against those whose rates of return
exceed their allowable rates. Thus, if a company is successful in efforts to substantially reduce operating
costs it may find itself in the odd position of being called before the PUC to justify the “excess” earnings
that result.
The case questions relate to the perceived need of Southwestern Bell managers to either change
the process by which the company subsidizes the other Texas LECs or replace it with procedures which
would result in a more equitable distribution of revenues. Instead of trying to provide the correct answer
to each question, students should focus on the relative merits of alternative courses of action. Also, they
should recognize that what has been labeled “the accountant’s creed” ⎯a more complex solution is a
better solution⎯is not necessarily true in this situation. The FCC’s process is very complex; students may
recommend simpler procedures which they believe would be preferable.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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Answers to Questions
1. For the perspective of SW Bell management accountants, the separation of non-traffic-sensitive (NTS)
costs by the frozen 1982 intrastate toll factor of 20% is the primary source of inequities in the current
pooling procedures. This factor greatly understates the current portion of SWBT’s expense and
investment amounts related to intrastate long distance service. If allocation factors based on actual current
even suggest that subsidies should be discontinued. They argue that although some smaller carriers might
not survive, the market system will attract companies that can provide telephone service profitably with
today’s new low-cost technology.
2. SW Bell officials could go to the PUC and ask for additional supervision and regulation to correct the
perceived inequities in the current system. They could point out that although the costs of telephone
technology have been declining steadily in recent years, the poolable expenses of the other LECs have
been increasing. SWBT representatives could argue that the relatively high costs of those companies may
be explained to some extent by the toll revenue sharing arrangement, which gives them little incentive to
reached among the larger companies, the smaller ones would have little choice but to accept a new
arrangement. Regardless of the direct negotiation approach selected, the companies involved would have
considerable flexibility in deriving an equitable settlement plan, although it necessarily would mean lower
payments to some if not most of them.
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3. The students’ answers to this question could vary as their attitudes toward governmental versus free
market solutions, big versus small companies, gradual versus rapid change, and the rights of a company’s
shareholders versus the rights of the customers. The focus of the case and wording of the questions
probably will lead many students to recommend some change that would reduce the subsidies SWBT
pays to the other LECs but stop short of immediately discontinuing them. Students should expect the
actual solution to be a compromise that is not entirely satisfactory to any of the affected parties.
SW Bell and several of the other large LECs recently informed the TECA and the PUC that they were
withdrawing from the pool. SWBT then reached separate agreements with the larger and smaller
PUC data indicate that the reduced subsidies to be paid under the new arrangement are sufficient to
maintain universal service in the state. Finally, the large companies now have additional incentives to
control costs, although incentives for the smaller companies remain inadequate. SWBT managers would
like to move the latter LECs to fixed payments after the agreement expires, and then gradually “wean”
them away from financial dependence on the company.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-2. Brookwood Medical Center
The Brookwood Medical Center (BMC) case focuses on the new TSI accounting system. Concepts such
as direct and indirect costs and simultaneous algebraic allocations are addressed in a strategic context.
• Look at the quote from Carolyn Johnson at the beginning of the case. She states that upon losing
the bid for open hear surgeries, she did not know whether to be disappointed or relieved.
Ask the students to explain the basis for her reaction. Link the discussion to the Introduction case, CCR,
cost averaging. Managers at Brookwood did not have a clue about the cost of procedures. Ask the
students to think about the implications of long-term contracts. What if Brookwood acquires a contract at
a price below cost because the cost system is inadequate to help them accurately determine procedure
costs?
Answers to Questions
1. Costs were evaluated in aggregate. Also, the system focused on “charges” (a meaningless concept for
cost management purposes).
2. Consider the impact of variation in practice patterns across individual physicians. The managers at
Brookwood also were concerned with the cost of appropriate care. For example, some physicians ordered
out is that 80% of a person’s lifetime health care costs are spent in the final 90 days of life.
3. Draw a chart of the TSI system and point out the key principles as in the schematic below. The major
point is to stress that the indirect costs are allocated to revenue-producing departments using simultaneous
algebraic equations. In the second stage, both indirect and direct costs are applied to the patient using a
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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4. Consider how the daily rate (case Table 2) is determined for the Nursing Med/Surg department acuity
level 1 (based on information in case Table 3).
18 days x 346 minutes per day = 6,228 minutes
Acuity level 2 ($140) is calculated in an identical manner.
Why do we adjust for minutes of care? This captures the level of care required by different acuity levels.
Discuss intensive care with around the clock attention versus a step-down level of care with periodic
nursing visits. Consider the different rates at which resources are consumed.
5. At this point, you can begin the analysis by discussing the logic of the simultaneous algebraic equation
method. Case Table 4 illustrates an example of an iteration from the accounting system. Also, you can
work a simple manual example as follows:
HK = 60,000 + .10 (IS)
IS = 121,649
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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Solve the allocation using the allocation percentages as follows:
IS
HK
OR
ER
100,000
60,000
-0-
-0-
(121,649)
12,165
60,824
46,660
21,649
(72,165)
28,866
21,650
-0-
-0-
89,690
70,310
Case Table 5 is a printout from Brookwood’s TSI system. Notice that both revenue-producing and service
departments are included in the list. Education costs are allocated to the emergency room as follows: ER
= 124,212/4,886,856 = .0254
.0254 x $500,000 = $12,708
Iterations such as this would continue until all service department costs were allocated to revenue–
producing departments.
6. This question permits a discussion of the key elements found in ABC systems according to Cooper’s
hierarchy (unit level, batch level, product sustaining, and facility sustaining). Interestingly, we observed
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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Case 7-3 Business Services Corporation
The case involves the allocation of the indirect costs associated with holding and distributing replacement
parts used in servicing the computer and other business products sold to customers under a service
agreement. The company has two business units, the computer division and the business products
division. The source of the issue in the case is the determination of an appropriate method for allocating
the indirect costs of holding and distributing replacement parts used by both divisions. The costs
involved are significant. The company stocks 100,000 different parts in 40,000 locations. Further,
although a small number of parts may never be needed, the firm feels it must have at least a few units of
every part on hand so that it could service every customer’s need. This policy leads to obsolescence of
parts, an additional cost to that of storing and distributing the parts. At the time of the meeting described
in the case, parts overhead was averaging 70% of the cost of the parts charged directly to the product.
To put the issue in perspective, Exhibit 1 shows how each item in parts overhead is related to the
activity in the two divisions.
Exhibit 1: Relationship of parts overhead costs to activities in the two divisions.
Association With (usage by..)
Computer Division
Business Products
Explanation
low
high
Most of the low value parts are used
by the business products division
low
low
These are random costs and small in
amount
high
low
The parts needed for the computer
division are generally much more
expensive and the need for parts much
more difficult to forecast. Demand
for business products’ parts are
relatively easy to predict
high
low
Again, computer parts are very
expensive and tend to stay in
inventory for long periods. Business
products’ parts turn over quickly
low
high
Very large volumes of business
products’ parts flow through the
system
Note that the current allocation method allocates all overhead on the basis of the cost of those parts (in
excess of $10 per part) actually used. The computer division feels this approach over charges the unit for
obsolescence and holding costs. Both divisions, in effect, are arguing that the allocation method does not
capture cause-and-effect relationships.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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Answers to questions:
1. The objectives of cost allocation are to motivate managers to work hard, to make decisions that
are consistent with top management’s strategy, and to provide a cost allocation method that
managers perceive to be fair.
2. What are the options to the current method? One option would be to trace all direct parts costs
(including cost of parts costing less than $10) to products and allocate overhead on this more
comprehensive measure of direct costs. This would solve one of the object is of the computer
division. Another possibility is to allocate on the basis of the number of parts used instead of
parts inventory, identifying those parts which are used exclusively by one division and summing
the costs of those unique parts for each division. In contrast, distribution and non-product usage
costs appear to vary with volume of activity. A volume measure such as the number of jobs
performed by each division might be satisfactory for these costs.
What the firm actually did:
The meeting ended with the president appointing a task force headed by the direct of accounting.
The task force recommended the following actions that were then implemented. First, all parts, including
low-value parts, that can be directly t4raced to a product or group of products are now charged to those
remaining obsolescence costs and the costs of carrying inventory are now allocated based on an estimate
of the dollar value of average inventory carried for each product line.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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Teaching Strategy for Readings
“Managing Shared Services with ABM”
This article outlines the benefits of using shared services (i.e., finance and accounting services) in
large companies such as Ford Motor company, Sun Microsystems and Marriott. There is also a
discussion of how activity-based management (ref: Chapter 5) is used to manage the costs of these shared
services.
Discussion Questions:
1. How do the concepts of cost management for shared services differ from the concepts and methods
presented in chapter 7?
The concepts for cost management of shared services (chapter 5) differ from the concepts and
methods presented in Chapter 7 in the following way. The concepts for cost management of shared
services focus on identifying the cost drivers of the services, and on reducing these costs through
support department costs when activity-based costing is unlikely to be applied because of low complexity
of the manufacturing process, homogeneity of cost flows to products, or for other reasons.
2. Who are the customers referred to in the article?
The customers are the internal users of the firm’s support activities, in contrast to the
3. What do you think is the best way to manage the costs of shared services such as finance and
accounting?
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7-2 “Simpler than ABC New Ideas for Using Microsoft Excel for Allocating Costs”
This article looks at a new method for service department cost allocation using Excel. It includes
important tips about making a useful Excel spreadsheet and it also factors in alternative methods to
compare against accounting for service department costs.
Discussion Questions:
1. Define an argument against the use of service department allocations.
Many reasons against allocating these costs refer to the arbitrary nature of the allocation method and the
distorting influence of these costs. The accuracy of the assignment of cost is in large part a function of the
2. In what cases should service department allocations be used instead of activity-based costing?
service cost allocations remain in use
3. What are some key factors in making a useful Excel worksheet?
1. Start by constructing formulas that take into account all cost flows in and out of the service department
to other service departments only.
5. If summed, the columns should equal 1.
6. The coefficient matrix forms the basis for the remaining matrices. There will be one matrix for each
service department plus the coefficient matrix. Service department matrices are constructed by replacing
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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8. Divide the individual service department. Determinants by the determinant for the coefficient matrix (
Cramer’s Rule). The result(s) are your allocated reciprocal costs for each service department. Summing
9. When allocating the costs from the service departments to the production departments, use the total
4. Explain why the matrix method can be seen as more efficient than the traditional method.
The matrix method demonstrated here avoids the double counting problem of the traditional method and
provides an intermediate cost, which can be directly associated with each service department. In addition,