Cost and Revenue Allocations

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Cost and Revenue Allocations

• EMBA 5412 Fall 2010

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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

• To provide information for economic decisions
• To motivate managers and other employees
• To justify costs or compute reimbursement
• 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
  objects 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
• Budgeted overhead rate and budgeted hours
• Budgeted overhead rate and actual hours
• 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
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Service Allocation Direct Method

• Procedure
• Ignore each service departments 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
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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
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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
  divisions planned use of the service
  departments 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
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Direct Method
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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
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step-down with information system first
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Comparison of Methods
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Reciprocal computation
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Reciprocal allocation
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Comparison
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(No Transcript)
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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
• Dubna
• St.Peterburg
• 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
• The contractor is paid a set price without
  analysis of actual contract cost data
• 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
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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
Based on physical units
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Joint costs example
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Joint costs example
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Joint costs comparison
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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
• Selling Prices
• Unit Costs
• 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.

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Example
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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
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Example-Shapley allocation
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Example-Shapley value
Assume equal weights on all products.