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Lecture 9

AYB225 - Lecture 9 Notes

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LECTURE 9 – COST ALLOCATION ISSUES SERVICE DEPARTMENT COST ALLOCATION This topic will cover: (1) How to determine the share of service department costs, and then (2) Including the SD allocation in the numerator when calculating the OH rates of production departments (consequential on (1)). Allocating Service Department Costs – General Principals Assumptions of Service Department Allocation  Most service departments provide services for: 1. Themselves (B provides power for itself) 2. Other service departments (B provides power for A) 3. Production departments (B provides power for X and Y) 4. Other non-production departments (B provides power for selling/admin/other depts not mentioned)  This topic, by convention, considers only (2) and (3). (1) and (4) are ignored.  With respect to (4), in problems in this unit, data which is not relevant for the production departments have already been removed. When Does Service Department Allocation Occur?  Only consider this issue where service (support departments) exist, but also only when: o The production departments want to include a share of SD costs in their OH rates, and o There is more than one production department. What Service Department Allocation Does NOT Do: (1) It is an accounting allocation exercise only, for the purposes of inventory valuation. The calculation shows zero costs remaining in the service departments, but costs are not physically removed. (2) The allocation does not remove the responsibility of the cost from the department incurring the cost, i.e. the service department. Production departments do not become responsible for the service department costs, only for their use of the service department costs. Issues Common To All Methods (1) The figures used in the allocation are budgeted figures (this happens in advance of the period), because we are doing the calculation for the purpose of determining the budgeted OH rates. (2) The allocation can be carried out using:  a table format (the method of setting out used is recommended but is not mandatory), or  billing rates (charge-out rates) Students may choose either method for examination purposes. (3) Once SD costs have been allocated to PDs, they are included in the PDs OH rates. DM and DL of the production departments are therefore not required for this exercise Three Methods of Service Department Allocation Direct Method  The simplest and most widely used method.  Allocates all service department costs to production departments only. In other words, even if SDs service each other this inter-service-departmental activity is completely ignored. The allocation is made according to the relative proportions of use by the PDs only. Becauseof the choice we havemade about treatmentof fixed andvariable SD costs, the allocated SD costs areadded to the variable OH of the production departments. This means that the fixed OH rate is calculated once, and remains the same acrossthe differentSD allocationmethods. WORK EXAMPLE PAGE 3 HERE Step Down Method  The step-down method recognizes inter-service department servicing UNLESS doing so would force us to break the rule: onceSDcostsareallocated out,youcannotallocatethembackin  Whenthismethod isused,firmsmustchoosetheorderin whichto allocate SD costs. There area numberofcriteria thatcanbeused,e.g.allocateaccordingto: o cost o thenumberofother SDs service o thepercentageoftimespent servicingotherSDs,etc. In thisunityouwill betoldtheorderofallocation,definitelyforexamination purposes, andformost questions. WORK EXAMPLE PAGE 4 HERE Reciprocal Services Method – NOT EXAMINABLE Using Billing Rates  An alternative to the table format is to calculate billing rates (charge-out rates) and use these rates to allocate the SD coststo PDs.  A general formula for the billing rates is: Total amount of SD cost that will be allocated across other departments Total usage of SD that is recognised in the allocation method  Both the numerator and the denominator depend on the method of SD allocation chosen. Refer back to the tables (for direct and step-down only) and work carefully through each of the three examples to see how the numerator and denominator are derived. WORK EXAMPLE PAGE 5 HERE COST ALLOCATION – JOINT PROCESSES  The final cost of a product for inventory valuation purposes will be the product cost at the end of all production processes necessary to manufacture that particular product, whether they be simple processes (like the skateboard example) or include one or more joint processes.  Consistent with the behaviour of “product costs”, costs will move with the goods through the production processes.  When the goods are finished, we can determine the product cost by adding all the costs allocated to a particular product, and averaging the cost across the number of units of product. Definitions Begin any joint cost allocation question by diagramming the problem  The first thing you need to notice is that, unlike the Ready-Roll skateboards example where the product passed through all processes, here the products do not pass through all processes. Juice, cider and pulp all pass through process 1, but then they are treated differently. When production is completed: o Juice is processed through process 1 only. o Cider is processed through processes 1 and 2, and o Pulp is processed through processes 1 and 3. DRAW DIAGRAM PAGE 6 HERE Joint Process, Joint Products, Joint Costs  Process 1 is a joint process. A joint process is a process which: o yields two or more products or by-products simultaneously at an identifiable point, where o it is not possible to identify (distinguish between) the individual products prior to that point.  Juice, Cider and Pulp are called joint products or multiple products. Joint products are products that have a significant sales value and that emerge from a joint process.  The $240,000 costs of Process 1 are called joint costs. Split-Off Point  The split-off point (SOP), represented by the vertical line on the diagram, is the point at which the individual products become distinguishable. o Prior to that point it is not possible to determine how much production effort is involved (in this example) in juice, cider and pulp, because the products do not separately exist until the split off point. Separable Costs  The additional production costs incurred in Process 2 and Process 3 ($.67 for Cider and $1.50 for Pulp) are called separable costs. (They are often referred to simply as “costs beyond split-off”.) Separable costs apply only after the individual products become identifiable, and are therefore able to be traced (identified with) the individual products. o In contrast, joint costs cannot be identified with the individual products. This means that firms must allocate these joint costs to the different products in some way, so that firms are able to cost their products. The Allocation Issue Explained  The purpose of allocation is to enable firms to value inventory. o The allocated joint costs are added to the costs of any other processes through which the product passes to determine the cost per unit, which is then used to value WIP, FG and COGS. Methods of Joint Costs Allocation  As with all cost allocation methods, methods are arbitrary, and one is no “better” than another. o Because it is not possible to identify the individual products during production in the joint process, it is therefore impossible to say that one method “better reflects” the costs incurred on the different products.  Firms will choose an allocation method which best suits their circumstances.  Joint cost allocation methods are either based on: (1) Physical measures (method 1), or (2) Sales value (methods 2,3,4)  Physical measures allocates the joint costs according to some physical measure at split-off point, e.g. number of units, weight of units. This method: o is the simplest, therefore lowest cost method, but o the allocation may bear no relationship to the revenue-earning potential of the individual products (some firms find this to be a problem, others do not).  Allocation is always across the units PRODUCED in the process, not the units sold.  The joint costs of $240,000 are allocated across Juice, Cider and Pulp according to the number of litres produced (not the number of litres sold). This is because it is logical to do so. It cost the firm $240,000 to produce 150k, 90k and 60k litres of juice, cider and pulp respectively, therefore that cost should be allocated across the 150k, 90k and 60k, not any other figure (e.g. not 140k, 60k and 50k units sold). o (For all methods, units sold MAY need to be used to calculate units produced, but it will NEVER be used to determine the proportion used for the allocation.) Physical Methods  Two different physical measures could be used in the lecture example. o One alternative is to allocate according to the number of joint products (not common, but it is a legitimate physical measures method).  In this case there are three products, so each product would be allocated 1/3 of the joint costs, ie $80,000 each. o A second alternative would be a “weighted” measure – in this case in proportion to litres of each product: DRAW TABLE PAGE 7 HERE Sales Value at Split-Off Point  This method allocates the $240,000 joint costs across the products in proportion to the sales value at split-off of the units produced.  Allocation would be in proportion to the units produced x SP at SOP, as per the following table: Sales value at SOP Allocation Juice 150,000 x .70 $105,000 Cider 90,000 x ? Pulp 60,000 x ?  As the name suggests, it requires the sales value of products at split off point, therefore it can only be used when a sales value at split-off is available for all products. o In this case one is available only for Juice, because it is not possible to sell Cider and Pulp without further processing.  Therefore this method cannot be used by the firm. Estimated Net Realisable Value  The term "net realisable value" (NRV) used in this context means the sales value less any costs identifiable with the individual products.  This method allocates joint costs in proportion to: o sales value at the normal point of sale o brought back to estimated (or actual) sales value at SOP by subtracting separable costs (if any). DRAW TABLE PAGE 8 HERE By-Products Defined  Joint products are products emerging from the joint process with significant sales value.  A by-product is an item with insignificant sales value when compared with the principal products. o Firms would have to decide “how much” is significant/insignificant. Joint Cost Allocations Involving By-Products  Any of the above joint cost allocation methods can be used when one of the items emerging from the joint process is a by-product.  The new issue for the allocation is “how to treat the by-product?”. There are two methods: o Treat by-product revenue as miscellaneous income, or o Treat by-product net revenue as a reduction of the costs of the principal products.  Regardless of which method a firm chooses, joint costs are never allocated to a by-product. The solutions in both methods below indicate that no cost is allocated to the by-product, but only to products A, B and C. NRV of By-Product Treated as Miscellaneous Income  This is the more common treatment found in practice. Under this method, you: o ignore the by-product until it is sold (don’t record anything until the product is sold) o allocate total joint costs to joint products only o when sold, record by-product revenue as miscellaneous income  The lecture example has already calculated the NRV, so we can omit the first two columns. The allocation of joint costs to products under this treatment of the by-product is: DRAW TABLE PAGE 9 (4.2.1) HERE NRV of By-Product Reduces Costs of Joint Products  Another treatment is to use the NRV of the by-product to reduce the cost of the joint products. This is achieved by reducing the joint costs prior to the allocation. Limitations – All Cost Allocations  The purpose of both service department and joint cost allocation is to enable the valuation of inventory (which includes the valuation of cost of goods sold).  Cost allocation always involves considerable subjectivity. Consider the three cost allocation issues you have covered in the course. (1) OH allocation. The amount of OH charged to jobs depends on the number of cost drivers chosen, which cost drivers are chosen, the level of the cost driver, the estimate of OH cost. The more rates used, the more accurate the product costing, consequently Activity Based Costing is typically promoted as the most accurate overhead allocation method. (2) Service department allocation. The amount of service department cost allocated depends on the method of allocation, the allocation base, and whether separate allocations occur for fixed and variable costs. These decisions are arbitrary. It can be claimed that the reciprocal services method is the most accurate, but that is only in terms of the amount of recognition given to inter-SD servicing. Compare the allocations using three methods for the lecture example (shown below). The results for the direct method (the simplest method, but least accurate in terms of recognition of inter-SD servicing) provides a very close approximation to the results for the reciprocal services method. It is not surprising, therefore, to find that many firms in practice elect to use the direct method of SD allocation. DRAW TABLE PAGE 10 HERE (3) Joint cost allocation. This is also subjective and arbitrary. The table below compares the total costs allocated to the three products in the lecture example. These $ differences are due simply to a choice of method. DRAW TABLE PAGE 10 HERE  If the figures above depend on arbitrary choices, firms must recognise that the joint cost allocations are for the purposes of inventory valuation, and either should not be used for decision-making at all, e.g. for decisions such as o actions to take with respect to the product after split-off o relevant profitability of one product vis-a-vis another o evaluating the performance of managers of subsequent processes o ranking of products o or should be used with extreme caution e.g. pricing of products.  Note that with all cost allocations, management will choose between the available methods. If the firm wants the benefits of more accuracy, it must weigh up the benefits against the additional costs, and the final “arbitrary” choice will be made usually on cost-benefit grounds. LECTURE EXAMPLE LECTURE EXAMPLE 1 – SERVICE DEPARTMENT ALLOCATION A firm has two products, one manufactured entirely in Department X, the other in Department Y. The firm has two service departments: A (material-handling) and B (a power-generating). An analysis of the work done by Departments A and B in a typical period follows. Each work unit for Department A represents a direct-labour hour of material handling time. Each workunitforDepartmentBrepresentsakilowatt-hourofpower. USER SOURCE A B X Y Materialhandling(DeptA) 0 40 100 60 =200 units(DL hours) Power(Dept B) 150 0 30 120=300units(kwhours) The budgeted costs of the service departments during this typical period are $10,000 for A and $4,000 for B. For the step- downmethod,allocatefromBfirst. Budgeted production departmentcostsforthe period: X Y DM 20,000 22,000 DL 11,000 13,000 F OH 7,000 9,000 V OH 5,000 7,500 OH base 10,000machine hours 15,000DLhours LECTURE EXAMPLE 2 – JOINT COST ALLOCATION A firm incurs DM, DL and OH costs totalling $240,000 in process 1 to produce the following three beverages from that process: Apple Juice Sold immediately it emerges from Process 1 without further processing for $.70 litre Apple Cider Processed further in Process 2 - additional cost $.66667 litre. Sold for $1.50 litre Apple Pulp Processed further in Process 3 - additional cost $1.50 litre. Sold for $3.50 litre. The following data relates to the period in which the joint costs were incurred: Beverage Litres producedLitres sold Apple Juice 150,000 140,000 Apple Cider 90,000 60,000 Apple Pulp 60,000 50,000 300,000 250,000 LECTURE EXAMPLE 3 – JOINT COST ALLOCATION - BY PRODUCTS A firm produces three items through a joint process (total costs of the joint process are $180,000). The net realisable values of units produced in the period are: Product A $20,000 Product B $30,000 Product C $40,000 By-product $ 4,950 Show the allocation of the joint costs. Use the NRV method of allocating joint costs to products, assuming two different method of treating the by-product. TUTORIAL QUESTIONS QUESTION1 Theallocationofservice departmentcostsandjointcostshaveasimilarpurpose. What isthat purpose? QUESTION 2 (a) Use the tables provided and show the allocation of service department costs using the following data and assuming the following methods of service department allocation. HR is allocated according to the number of employees, and computing according to processing time: (i) Direct method (ii) Step-down method allocating HR first (iii) Step-down method allocating Computing first. (b) What is meant by the term “service (supp
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