Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
7-1
CHAPTER 7:
COST ALLOCATION: DEPARTMENTS, JOINT PRODUCTS,
AND BY-PRODUCTS
QUESTIONS
7-1 The four objectives in the strategic role of cost allocation are to achieve effective
cost management through methods which:
1. Determine accurate departmental and product costs as a basis for evaluation
the performance of the department or profitability of the product.
2. Motivate managers to exert a high level of effort to achieve the goals of top
7-2 Joint products and by-products are derived from processing a single input or a
common set of inputs. Joint products are products from the same production
classified as by-products.
7-3 Reciprocal service flows are the service flows between service departments in
departmental allocation. These flows are ignored in the direct method, they are
7-4 There are three methods for departmental cost allocation: the direct method, the
step method, and the reciprocal method.
The direct method of cost allocation is done by taking the service
department flows to production departments only and determining each
production department’s share of that service.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-5 The three phases of departmental cost allocation, which apply for each of the
three methods (Question 7-4) are:
1. The initial allocation of all production and service costs to departments
2. The allocation of service department costs to production departments
3. The allocation of costs of production departments to products
The first phase in departmental cost allocation has two parts: to trace the direct
manufacturing costs in the plant to each service and production department that
service departments. These are often called reciprocal flows.
The third phase is to take the costs accumulated in the producing departments
and to allocate these costs to the final cost objects⎯the products or services.
7-6 There are a number of possible answers here. The chapter gives an example of
the use of departmental cost allocation in the banking industry. Other examples
would include cost allocation in an electric utility company to provide a basis for
use cost allocation to allocate the cost of the bank’s various internal departments
to the services provided by the bank, as a basis for setting fees and for
assessing the profitability of the services.
7-7 There are four methods for by-product costing:
The two asset recognition methods are:
Method 1 – Net Realizable Value Method. This method shows the net
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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The two revenue methods are:
Method 3 – Other Income at Selling Point Method. The net sales revenue
from a by-product sold at time of sale is shown in the income statement as an
other income or other sales revenue item.
Method 4 – Manufacturing Cost Reduction at Selling Point Method. The
Asset recognition methods are based on the financial accounting concepts of
asset recognition, matching, and materiality. By-products are recognized as
assets with probable future economic benefits since there is a market for them.
Asset recognition methods also have the preferred effect of matching the value of
the by-product with its manufacturing cost.
7-8 and,
7-9 There are a number of limitations and implementation issues to consider when
using either joint cost allocation or departmental cost allocation.
One issue is that it is often difficult to determine an appropriate allocation
the allocation, can help to reduce the effects in (a) and (b). Also, regarding (c),
to motivate managers to be efficient, and to make the right decisions, the
allocation in this case should be based on the cost to each department if it were
to obtain the service from outside the firm.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-10 A number of ethical issues are important when implementing cost allocation
methods. First, there are ethical issues when cost allocation is used in a situation
where the products or services are produced for both a competitive market and
for a public agency or government which is paying on a cost-plus basis. There is
an incentive for the provider to allocate an unfairly high portion of joint costs to
the cost-plus customer.
A second issue is the equity or “fair share” issue that arises when a
of taxes paid in the U.S. and the foreign country. Firms can reduce their world–
wide tax liability by increasing the costs of products purchased in high tax
countries, or countries where the firm does not have favorable tax treatment. For
this reason, international tax authorities watch closely the cost allocation
methods used by multinational firms.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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BRIEF EXERCISES
7-11
Total cost allocated to P1 is $20,000 and to P2 is $30,000
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Totals for All Departments
30,000$ 20,000$ 100,000$ 150,000$
SECOND PHASE: Reallocate Service Department Costs to Production Departments:
The Direct Method
Service 1 Service % to producing departments 35.0% 35.0%
Allocation % per the direct method 50.0% 50.0%
Allocation amount
(30,000)$ 15,000$ 15,000$
Service 2 Service % to producing departments 20.0% 60.0%
Allocation % per the direct method 25.0% 75.0%
Allocation amount (20,000)$ 5,000 15,000
Total Service Department Cost Allocated
20,000 30,000
Totals for Production Departments
120,000$ 180,000$
7-12 See 7-11 above, the total for P1 is $120,000 (= $100,000+$20,000), and the total
7-13
Total cost allocated to P1 is $17,750 and to P2 is $32,250
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Totals for All Departments
30,000 20,000 100,000 150,000
SECOND PHASE: Reallocate Service Department Costs to Production Departments:
The Step Method
First Step
Service 1 Service % 30.0% 35.0% 35.0%
Amount (30,000)
9,000 10,500 10,500
Second Step
Service 2 Service %
20.0% 60.0%
Allocation percent per direct method
25.0% 75.0%
Amount (29,000) 7,250 21,750
Total Service Department Cost Allocated
17,750 32,250
Totals for Production Departments 117,750$ 182,250$
7-14 There will be no change. The cost allocation is for service department cost (for S1
and S2); these costs are allocated to the production departments.
7-15, 16
P1
P2
S1
40%/60% = 2/3
20%/60% = 1/3
S2
40%/80% = 1/2
40%/80% = 1/2
for 7-15; 2/3 for P1 and 1/3 for P2
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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for 7-16 ½ for P1 and ½ for P2
7-17,18
The cost allocations are shown below.
7-19
First, the net realizable value of the by-product, $2,000 is reduced from the total joint
product cost; the by-product is inventoried at $2,000, and the remaining joint cost of
$98,000 is allocated to products 2 and 3 using the net realizable value method, as
follows:
7-20
Sales Value:
Sales Value Percent of Allocated
Product at Split-off Sales Value Joint Cost
1 50,000$ 49.02% 49,020$
2 50,000 49.02% 49,020
3 2,000 1.96% 1,960
102,000$ 100,000$
Sales Value: Units:
Sales Value Units at Percent of Allocated Percent of Allocated
Product at Split-off Split-off Sales Value Joint Cost Sales Units Joint Cost
1 130,000$ 240 65% 65,000$ 10% 10,000$
2 50,000 960 25% 25,000 40% 40,000
3 20,000 1,200 10% 10,000 50% 50,000
200,000$ 2,400 100,000$ 100,000$
Sales Value Percent of Allocated
Product at Split-off Sales Value Joint Cost
1 50,000$ 50.00% 49,000$
2 50,000 50.00% 49,000
3 2,000 2,000
102,000$ 100,000$
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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EXERCISES
7-21 Cost Allocation, General (15 min)
1. Service and administrative costs are costs that are incurred by
headquarters’ staffs or other central units. In order to maintain the
as administrative costs.
2. Homogeneous cost pools are collections of costs that are similar in
nature and have a presumed causal connection. Examples of
homogeneous pools include personnel-related costs, payroll-related
costs, space-related costs, and energy-related costs. A cost object
benefit from particular costs should share responsibility for these
costs. The “cause” criterion focuses on the cost objects that
precipitated the costs involved. The cause criterion is often applied to
service costs and allocates these costs to those units or cost objects
that gave rise to these costs.
b. The “ability to bear” criterion, which is similar in objective to
the benefit criterion, is based on the ability of the cost objects to cover
or absorb costs and allocates costs based on the profits of the cost
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-22 By-products and Decision Making (15 min)
Joe is considering a fruit-liquid, which is a by-product of the
processing for his jams and jellies, to produce a new product – a
coffee flavoring to complement his line of gourmet coffees. Joe is
correct in understanding that the production cost of jams and jellies is
selling costs.
The more critical consideration is the strategic issue: will the
new product line enhance the sales of coffees and the overall image
of Joe’s business as a high-end, quality gourmet business? Joe might
consider some form of consumer survey or marketing research to
determine whether the new product line would contribute as he
expects to the strategic competitive position of the firm.
7-9
7-23 Federal Reserve Banks; Cost Allocation (10 min)
By using an allocation method that resulted in lower costs being assigned
to the price-sensitive services, the FED was able to lower the full cost and,
therefore, the price of its most price-competitive services. As
demonstrated throughout this chapter, there are a number of alternative
see which one provides the best for their purposes; this is the approach
which should be considered unethical and inconsistent with the
management accountant’s code of ethics (see chapter 1).
Based on information in Ken S. Cavalluzzo, Christopher D. Ittner, and
David F. Larcker, “Competition, Efficiency, and Cost Allocation in
Government Agencies: Evidence on the Federal Reserve System,” Journal
of Accounting Research, Spring 1998, pp. 1–32;
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-24 Cost Allocation and Taxation at Nonprofit Organizations (10 min)
The nonprofit has an incentive to allocate a relatively large portion of the
common costs to the business activity to reduce taxes, but current
Treasury regulations require that the cost allocation be reasonable. This
has led some to argue that common costs should not be allocated in these
Treasury stance, which allows “reasonable” cost allocations.
Based on an article by Richard Sansing, “The Unrelated Business Income
Tax, Cost Allocation, and Productive Efficiency,” National Tax Journal,
June 1998, pp. 291–302.
7-11
7-25 Fuel Surcharges: Allocating the Increased Cost of Fuel (20
min)
1.,2.
The rising cost of fuel has affected many industries, but particularly
those in the transportation industries. In air freight, trucking, and
railroads, the surcharges can be as high as 35% of average charges.
The surcharges can be a substantial portion of total revenues for
these firms. The practice of fuel surcharges has grown widely to
include many service firms, involving most types of deliveries of
products or services (florists, retailers, appliance repair, and many
others). Unfortunately, many of these surcharges do not seem to be
reduced or removed when fuel prices fall, as they did during fall of
2008.
The issue of surcharges for railroads has been a contentious
one for the shippers and railroads. There have been several law
suits regarding the conflicts and currently several of the largest U.S.
railroads are subject to a suit charging price fixing regarding their use
of surcharges. The railroads’ attempt to have the suit dismissed
recently failed in U.S. courts (https://ecf.dcd.uscourts.gov/cgi-
bin/show_public_doc?2007mc0489-138). Apparently the STB ruling in
January 2007 was ineffective in resolving the surcharge issue for the
railroads and shippers. One reason it may have failed is that it
did not provide clear guidance regarding what would be an
acceptable method for cost allocation. The shippers’ suggestion for
miles traveled is probably closer to a basis that would recover actual
fuel cost increases. Also, one might consider an allocation that is
based on both miles and weight of product shipped. The goal is to
find the causal link between the use of fuel and the railroads’ service
to the shipper.
The litigation is on-going, as of December 2011.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-25 (continued –1)
3. The sustainability issue arises in the case of rail transport because
rail transport is more efficient than truck transport. A shipper that
has the option between the two methods of transport should
Based on: Christine Hauser, “Shippers May Raise Fuel Fees,” The
New York Times, April 26, 2011; Mina Kimes, “Railroads: Cartel or
Free Market Success Story?” Fortune, September 26, 2011; John D.
Schultz, “Fuel Surcharge Lawsuits: Antitrust Fines Growing,” Logistics
Management, July 1, 2008;Gargi Chakrabarty, “Many Businesses in
no Hurry to Pass on Savings,” Rocky Mountain News, October 31,
2008.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-26 Cost Allocation and Legal Disputes (30 Min)
The actual case is based on a dispute between the Department of Health
and Family Services (DHFS) of the State of Wisconsin and St. Francis
Home in the Park (the nursing home). The judgments shown below are by
the State of Wisconsin Court of Appeals, dated March 23, 1999. The full
explanation of the case is at the following site:
http://caselaw.lp.findlaw.com/scripts/getcase.pl?court=wi&vol=wisctapp2%5C1q99%5C
98-0986&invol=1
1. The court determined that further documentation was not required,
but that the stated reason for charging these items to the nursing
home is persuasive, and that further, DHFS had not shown that it had
asked NCI for the documentation. The specific assignment of these
costs to the nursing home was therefore allowed.
2. The court determined that DHFS had “no substantial basis” for
disallowing the direct assignment of the nourishment costs to the
meal production.” The court concluded that DHFS had no
substantial basis to disallow the method used by NCI.
5. The argument that NCI competes in the same manner (cost
leadership) for both the nursing home and the apartment-retirement
home is arguable. Is there evidence that the retirement home is a
cost competitive business? Also, it is not clear how the argument has
anything to do with the issue of cost allocation.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-27 Cost Allocation; Cost Shifting (15 min)
1. The cost-shifting in this case is from the airlines (that experience
lower costs of baggage handling) to TSA (that experience a larger
number of “carry–on” bags to examine) and to the airline passengers
(who experience the discomfort of increased time in going through
survive in a difficult competitive and economic environment.
Passengers’ views are likely to be mixed, with many frustrated by the
new charges and delays, and others seeking low air fares.
3. Given the emphasis airline customers place on price, air travel has
become somewhat of a commodity. It is hard to differentiate the
different carriers. The “fees for services” approach is consistent with
this strategy as it keeps ticket prices low for those who want to avoid
the fees, and it effectively shifts some of the airlines costs to TSA.
Source: See Real World Focus “Commodities, Globalization and Cost
Leadership,” in Chapter 1. Also, Christine Negroni, “More Fees, More
Carry-Ons,” The New York Times, March 29, 2011, p B4; Michelle Higgins,
“Elite for a Day, In Coach for a Fee,” The New York Times, September 4,
2011.
Chapter 7 – Cost Allocation: Departments, Joint Products, and By-Products
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7-28 Departmental Cost Allocation (25 min)
1. The Direct Method
Net service to both Production Departments (Advertising and Sales)
for the Actuarial Service Dept:
100% – 80% = 20%
Advertising Department share: 10%/20% = .5
Sales Department share: 10%/20% = .5
Net Service to both Production Departments for Premium
Department:
Advertising
Department
Sales Department
Actuarial Department
cost allocation
$80,000 x .5 = $40,000
$80,000 x .5 = $40,000
Premium Department
cost allocation
$15,000 x .25 = $3,750
$15,000 x .75 =
$11,250
Add: Initial Production
Dept. Costs
$60,000
$40,000
Total Cost for Each
Production Dept.
$103,750
$91,250
2. Step Method