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?

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

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.

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.

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 costallocation 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

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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
DATA Support Depts Operating Depts Plant Information Maintenance Systems Machining Assembly Total Budgeted Manufacturing Overhead Cost before allocations (TL) Support work provided: By Plant Maintenance Budgeted Labor hours Percentage By Information Systems Budgeted Computer hours Percentage

600.000

116.000

400.000

200.000 1.316.000

1600 20% 200 10%

2400 30% 1600 80%

4000 50% 200 10%

8.000 100% 2.000 100%

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Direct Method
Budgeted Cost Support Departments Budgeted Manufacturing Overhead Cost before allocations Plant Maintenance Labor Hours Percentage Allocated Plant Main Cost Information System Computer Hours Percentage Allocated Info System Cost Total Budgeted Overhead 1600/ 200/ (1600+200) (1600+200) 0,889 0,111 (116.000) 103.111 12.889 728.111 Budgeted Cost Operating Machining Depts Assembly Total

600.000

116.000

400.000

200.000 1.316.000

(600.000)

2400 / 4000/ (2400+4000) (2400+4000) 0,375 0,625 225.000 375.000

600.000

116.000

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 t Support epart ent Budgeted anufactur ng er ead ost efore allocat ons Plant aintenance abor ours Percentage llocated Plant ain ost Infor ation System omputer ours Percentage llocated Info Sys Total Budgeted 1600/ 200/ (1600+200) (1600+200) 0,889 0,111 (236.000) 209. 8 26.222 89. 8 Budgeted t Op ting hining pt bl ot l

600.000

116.000 1600 20% 120.000

400.000 2400 30% 180.000

200.000 1. 16.000 4000 50% 300.000 8.000 100% 600.000

(600.000)

ost

236.000

er ead

526.222 1.316.000
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step-down with information system first

Support Departments Budgeted Manufacturing Overhead Cost before allocations Information System Computer Hours Percentage Allocated Info Sys Cost Plant Maintenance Budgeted Cost INFO SYS Budgeted Cost PLANT Operating Machining Depts Assembly Total

116.000

600.000 200 10% 11.600

400.000 1600 80% 92.800

200.000 1.316.000 200 10% 11.600 2.000 100% 116.000

(116.000)

Labor Hours Percentage Allocated Plant Main Cost

2400 / 4000/ (2400+4000) (2400+4000) 38% 63% 611.600 229.350 382.250

100% 611.600

Total Budgeted Overhead

722.150

593.850 1.316.000
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Comparison of Methods
Ste d w Ste d w Pla t ai I f Sys Direct first first 728.111 789.778 722.150 587.889 526.222 593.850 1.316.000 1.316.000 1.316.000

ac i i sse ly tal

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Reciprocal computation
[A]= Plant Info 0 0,2 1 0 1,00 -0,20 0,1 0 0 cost [C] = Plant Info 1 -0,10 1,00
m ltiply [I- A] inverse x [C] = 600.000 116.000 624.082 240.816

[I] =

[I- A]=

det [I-A] = 1/ det[I-A] = [I-A] inverse

0,98 1,02 0,204 0,102 1,0204

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Reciprocal allocation
Support epart ents Budgeted anufacturing verhead ost efore allocations . . llocation of lant aintenance ercentage 20% ount 24.082) 124.816 Allocation of Information System ercentage 10% Amount 24.082 (240.816) Total udgeted overhead for operating departments Budgeted st ant Budgeted st Info Sys Operati Machi i epts ssembl tal

. 30% 187.224 80% 192.653 779.878

. 50% 312.041

. 100%

10% 100% 24.082 536.122 1.316.000

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

Machining Assembly Total

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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 costallocation 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 =

800 ! 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: Costbased 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 splitoff 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

Raw MILK

Pasteurize

MILK

Process further

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 CO T 1 Sal s value at s lit off amount (lt,kg) sales price (lt, kg) Total Sales value Weights of sales value JO NT COST 1 Allocation joint cost 1 per lt or kg Milk 105.000 1,50 157.500 50,0% 50.000 0,48 Yogurt and C 105.000 4,00 420.000 50,0% 50.000 0,48 s 210.000

(100.000)

Based on physical units

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Joint costs example

J INT C T 2 ales value at split off a ount (lt,kg) sales price (lt, kg) Total Sales value Weights of sales value JOI T OST Allocation joint cost 1 per lt or kg Yogurt 75. ,50 262.500 60, 120. 1,60 heese 5. 7, 175. 40, 80. 3,

437.500

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Joint costs example

Using NRV J INT CO T 2 Sales value at split off amount (lt,kg) sales price (lt, kg) Total Sales value Separable Costs per kg ess Separable Costs Net Realizable Value at Split-off eights of sales value J INT C ST 2 Allocation joint cost 1 per kg Yogurt 75.000 3,50 262.500 0,60 45.000 217.500 63,50% 127.007 1,69 Cheese 25.000 7,00 175.000 2,00 50.000 125.000 36,50% 72.993 2,92
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437.500

342.500

(200.000)

Joint costs comparison

TOTAL COST per kg

sales value NRV

Yogurt Cheese 2,68 2,77

5,68 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 productspecific 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 per Unit Selling rice TL TL 125 18 150 20 225 25 220 280 305 380
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In ivi ually Writeperfect Computeperfect Graphperfect Bun le : Write and Compute Write and Graph Compute and Graph Write, Compute and Graph

Example
In ivi ual Revenue Allocation Use Selling rices total individual pri es 275 weights and pri es bundle pri e write 220 0,45 100,00 280 0,36 100,00 0,40 122,00 0,25 95,00 0,30 114,00

write and ompute pri es of individual produ ts write and graph pri es of individual produ ts ompute and graph

ompute graph 0,55 120,00 0,64 180,00 0,60 183,00 0,45 171,00
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350

375

305

write, ompute and graph

500

380

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 Revenue Allocated 125 220

Product Writeperfect

Bundle Write and Compute Write Compute Write and Graph Write Graph

Bundle Price 220

Revenue Allocated 125 95 280 125 155 305 150 155

125 280

Computeperfect Graphperfect

Compute and Graph Compute Graph write,compute and graph Write Compute Graph

150 305

380 125 150 105 125 275 380

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Example-Shapley allocation
Primary Write Write ompute ompute Graph Graph rder First in remental ompute Graph Write Graph Write ompute evenues Allo ated to ea h produ t Se ond In remental Graph ompute Graph 220 150 Write 380 305 ompute 280 225 Write 380 305 75 55 100 380 280 80 305 225 75 150 305 Write 125 125 70 ompute 95 220 125 100 380 280 150 380 280 380 Graph 160 220 155 125 160 220 155 150 225 225

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Example-Shapley value
rd r irst Pri Writ Writ t t r r ry i r Writ r Writ t v r ric = r t t l R v n c nd Incr nt l r t r Writ t Writ l yv l Writ s ll c t d t t c r d ct r

Assume equal weights on all products.

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