Allocation of Support Activity Costs and Joint...

After completing this chapter, you should be able to

1 Allocate service department costs using the

direct method and the step-down method.

2 Allocate service department costs using the

reciprocal-services method.

3 Use the dual approach to service department

cost allocation.

4 Explain the difference between two-stage cost

allocation with departmental overhead rates and

activity-based costing (ABC).

5 Allocate joint costs among joint products using

each of the following techniques: physical-units

method, relative-sales-value method, and net-

realizable-value method.

6 Describe the purposes for which joint cost alloca-

tion is useful and those for which it is not.

FOCUS COMPANY

This chapter’s focus company is Riverside Clinic, an outpatient medical facility in Fredericton, New Brunswick. The clinic has two direct-patient-care departments: Orthopedics and Internal Medicine. In these two departments, patients are treated by medical professionals. Riverside Clinic also has three service departments, which are not directly involved in patient care. The clinic’s Patient Records, Human

Resources, and Administration and Accounting departments are necessary for the clinic to function, but they operate in a support role to the two direct-patient-care departments. In this chapter, we explore several methods for allocat-ing the costs of the clinic’s service departments to the direct-patient-care departments.

IN CONTRAST

In contrast to the health-care services setting of Riverside Clinic, we explore a different type of allocation issue during a revisit to the International Chocolate Company. This company uses a joint production process to turn cocoa beans into cocoa butter and cocoa powder. The cocoa powder can be processed further into instant cocoa mix. A joint production process results in two or more products, which are called joint prod-ucts . We will discuss several different methods that International Chocolate Company might use to allocate the costs of its joint production process to its two joint products.

Allocation of Support Activity Costs and Joint Costs

CHAPTER FIFTEEN

RIVERSIDE

CLINIC

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2 Chapter 15 Allocation of Support Activity Costs and Joint Costs

In earlier chapters, we studied cost allocation and explored its role in an organiza-tion’s overall managerial accounting system. We also examined several purposes of cost allocation. The goal of cost allocation is to ensure that all costs incurred by the

organization are ultimately assigned to its products or services. This is important for several purposes, including cost-based pricing and bidding, cost reimbursements from outside parties such as insurance companies, valuation of inventory, and determina-tion of cost of goods sold. In addition, the allocation of all costs to departments serves to make departmental managers aware of the costs incurred to produce services their departments use.

Service Department Cost Allocation

A service department is a unit in an organization that is not involved directly in producing the organization’s goods or services. However, a service department does provide a service that enables the organization’s production process to take place. For example, the Main-tenance Department in an automobile plant does not make automobiles, but if it did not exist, the production process would stop when the manufacturing machines broke down. So the Maintenance Department is crucial to the production operation even though the repair personnel do not work directly on the plant’s products.

Service departments are important in nonmanufacturing organizations also. For example, a hospital’s Human Resources Department is responsible for staffing the hospital with physicians, nurses, lab technicians, and other employees. The Human Resources Department never serves the patients, yet without it the hospital would have no staff to provide medical care.

A service department such as the Maintenance Department or the Human Resources Department must exist in order for an organization to carry out its primary function. Therefore, the cost of running a service department is part of the cost incurred by the organization in producing goods or services. In order to determine the cost of those goods or services, all service department costs must be allocated to the production departments in which the goods or services are produced. For this reason, the costs incurred in an automobile plant’s Maintenance Department are allocated to all of the production departments that have machinery. The costs incurred in a hospital’s Human Resources Department are allocated to all of the departments that have personnel. Direct-patient-care departments, such as Surgery and Physical Therapy, are allocated their share of the Human Resources Department’s costs.

To see how service department cost allocation fits into the overall picture of product and service costing, it may be helpful to review Exhibit 3–12 in the textbook. The exhibit shows three types of allocation processes, as follows:

1. Cost distribution. Costs in various cost pools are distributed to all departments, including both service and production departments.

2. Service department cost allocation. Service department costs are allocated to production departments.

3. Cost application. Costs are assigned to the goods or services produced by the organization.

We are focusing on the second type of allocation process listed above. The context for our discussion is Riverside Clinic, an outpatient medical facility in Fredericton, New Brunswick.

The clinic is organized into three service departments and two direct-patient-care departments. Exhibit 15–1 displays a simple organization chart for Riverside Clinic. Since the clinic is not a manufacturing organization, we refer to direct-patient-care departments instead of production departments . These two departments, Orthopedics

Learning Objective 1

Allocate service department

costs using the direct method

and the step-down method.

RIVERSIDE

CLINIC


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Chapter 15 Allocation of Support Activity Costs and Joint Costs 3

and Internal Medicine, directly provide the health care that is the clinic’s primary objective; the clinic’s direct-patient-care departments are like the production depart-ments in a manufacturing firm. Notice that the Human Resources Department and the Administration and Accounting Department provide services to each other. When this situation occurs, the two service departments exhibit reciprocal services .

Exhibit 15–2 provides some of the details for our illustration of service department cost allocation. Panel A shows the proportion of each service department’s output that is consumed by each of the departments using its services. Panel B shows the allocation bases, which are used to determine the proportions shown in panel A. Further explana-tion of the information in Exhibit 15–2 follows the exhibit.

Servicedepartments Patient

RecordsDepartment

HumanResourcesDepartment

Administrationand Accounting

Department

Direct-patient-caredepartments

OrthopedicsDepartment

Internal MedicineDepartment

Exhibit 15–1Organization Chart for

Riverside Clinic*

RIVERSIDE

CLINIC

*The arrows in this organization chart depict the provision of service by the three service departments. For example, the Human Resources

Department serves the patient Records Department but not vice versa.

“Support, or service, depart-

ment costs are becoming a

greater and greater percent-

age of our cost structure.”

(15a)

Chrysler

A. Percentage of Service Output Consumed by Using Departments

Provider of Service

User of Service <Insert hiL26924_ta1701.eps>

Patient

Records

Human

Resources

Administration

and Accounting

Patient Records ................................... — 5% —

Service departments Human Resources ................................ — — 5%

Administration and Accounting .............. — 20% —

Direct-patient-care

departments

Orthopedics ......................................... 30% 25% 35%

Internal Medicine ................................. 70% 50% 60%

⎧⎪⎨⎪⎩⎧⎨⎩

B. Allocation Bases

esaB noitacollAtnemtrapeD ecivreS

Patient Records ........................................................................................................................ Annual patient load

Human Resources ..................................................................................................................... Number of employees

Administration and Accounting .................................................................................................. Size of department

(measured in square

metres of space)

C. Service Department Costs

Service Department

Variable

Cost

Fixed

Cost

Total Cost to

Be Allocated

Patient Records ............................................................................... $24,000 $ 76,000 $100,000

Human Resources ............................................................................ 15,000 45,000 60,000

Administration and Accounting .......................................................... 47,500 142,500 190,000

Total ................................................................................................ $86,500 $263,500 $350,000

Exhibit 15–2Provision of Services by

Service Departments in

20x1: Riverside Clinic

RIVERSIDE

CLINIC


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Patient Records The service output of the Patient Records Department is consumed only by the Orthopedics and Internal Medicine Departments. Annual patient load is the allocation base used to determine that 30 percent of the Patient Records Department’s services were consumed by Orthopedics and 70 percent by Internal Medicine.

Human Resources The Human Resources Department serves each of the clinic’s other departments, including the other two service departments and the two direct-patient-care departments. The allocation base used to determine the proportions of the Human Resources Department’s output consumed by the four using departments is the number of employees in the using departments. For example, 5 percent of the clinic’s employees (excluding those in the Human Resources Department) work in the Patient Records Department.

Administration and Accounting This service department provides services only to the Human Resources Department, the Orthopedics Department, and the Internal Medi-cine Department. A variety of services are provided, such as computer support, patient billing, and general administration. Since greater amounts of these services are provided to the larger departments, departmental size is the allocation base used to determine the proportion of service output consumed by each department. Since the space devoted to each department is a convenient measure of departmental size, square metres is the mea-sure used in Exhibit 15–2. For example, 5 percent of the clinic’s space (excluding that occupied by Administration and Accounting and Patient Records) is devoted to the Human Resources Department.

Panel C of Exhibit 15–2 shows the total budgeted cost of each service department that is to be allocated among the using departments.

There are two widely used methods of service department cost allocation, the direct method and the step-down method. These methods are discussed and illustrated next, using the data for Riverside Clinic.

Direct Method Under the direct method , each service department’s costs are allocated among only the direct-patient-care departments that consume part of the service department’s output. This method ignores the fact that some service departments provide services to other service departments so, even though Riverside Clinic’s Human Resources Department provides services to two other service departments, none of its costs are allocated to those departments. Exhibit 15–3 presents Riverside Clinic’s service department cost alloca-tions under the direct method.

Notice that the proportion of each service department’s costs to be allocated to each direct-patient-care department is determined by the relative proportion of the

Direct-Patient-Care Departments Using Services

Orthopedics Internal Medicine

Provider of Service Cost to Be Allocated Proportion Amount Proportion Amount

Patient Records . .......................... $100,000 3/10 $ 30,000 7/10 $ 70,000

Human Resources ........................ 60,000 25/75 20,000 50/75 40,000

Administration and Accounting ...... 190,000 35/95 70,000 60/95 120,000

Total ............................................ $350,000 $120,000 $230,000

Grand total $350,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Exhibit 15–3Direct Method of Service

Department Cost Allocation:

Riverside Clinic

RIVERSIDE

CLINIC


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service department’s output consumed by each direct-patient-care department. For example, Exhibit 15–2 shows that the Human Resources Department provides 25 per-cent of its services to Orthopedics and 50 percent to Internal Medicine. Summing these two percentages yields 75 percent. So 25/75 is the fraction of the Human Resources Department’s cost allocated to Orthopedics and 50/75 is the fraction allo-cated to Internal Medicine.

Step-Down Method As stated above, the direct method ignores the provision of services by one service department to another service department. This shortcoming is overcome partially by the step-down method of service department cost allocation. Under this method, the management accountant first chooses a sequence in which to allocate the service depart-ments’ costs. A common way to select the first service department in the sequence is to choose the one that serves the largest number of other service departments. The service departments are ordered in this manner, with the last service department being the one that serves the smallest number of other service departments. 1 Then the management accountant allocates each service department’s costs among the direct-patient-care departments and all of the other service departments that follow it in the sequence. Note that the ultimate cost allocations assigned to the direct-patient-care departments will differ depending on the sequence chosen.

The step-down method is best explained by way of an example. Riverside Clinic’s Human Resources Department serves two other service departments: Patient Records, and Administration and Accounting. The Administration and Accounting Department serves only one other service department: Human Resources. Finally, the Patient Records Department serves no other service departments. So Riverside Clinic’s service depart-ment sequence is as follows:

(1)Human

Resources

(2)Administration

and Accounting

(3)Patient

Records

In accordance with this sequence, each service department’s costs are allocated to the other departments as follows:

Cost Allocated from This Service Department To These Departments

Human Resources ............................................................................................................ Administration and Accounting

Patient Records

Orthopedics

Internal Medicine

Administration and Accounting .......................................................................................... Orthopedics

Internal Medicine

Patient Records ............................................................................................................... Orthopedics

Internal Medicine

Notice that even though Administration and Accounting serves Human Resources, there is no cost allocation in that direction. This results from the placement of Human Resources before Administration and Accounting in the allocation sequence. Moreover, no costs are allocated from Patient Records to either of the other service departments, because Patient Records does not serve those departments.

Exhibit 15–4 presents the results of applying the step-down method at Riverside Clinic. First, the Human Resources Department’s $60,000 in cost is allocated among the four departments using its services. Second, the cost of the Administration and

“Allocating service depart-

ment costs to the academic

units serves a variety of

purposes. For one thing, it

makes the [academic] units

aware that their activities

result in those costs being

incurred behind the

scenes.” (15b)

Cornell University


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Accounting Department is allocated. The total cost to be allocated is the department’s original $190,000 plus the $12,000 allocated from the Human Resources Department. The new total of $202,000 is allocated to the Orthopedics and Internal Medicine Departments according to the relative proportions in which these two departments use the services of the Administration and Accounting Department. Finally, the Patient Records Department’s cost is allocated.

Reciprocal-Services Method The direct method and the step-down method both ignore the fact that the Administra-tion and Accounting Department serves the Human Resources Department. Neither of these methods allocates any of the costs incurred in Administration and Accounting back to Human Resources.

Review the relationships between the service departments depicted in Exhibit 15–1. Notice that the Administration and Accounting Department and the Human Resources Department serve each other . This mutual provision of service is called reciprocal service . A more accurate method of service department cost allocation, called the reciprocal-services method , fully accounts for the mutual provision of services. The relationships between Riverside Clinic’s three service departments are portrayed in the following diagram.

Patient Records(Department R)

Human Resources(Department H)

Administration and Accounting(Department A)

The first step in the technique is to specify a set of equations that express the rela-tionships between the departments. The following equations, which express these rela-tionships for Riverside Clinic, are based on the data in Exhibit 15–2:

R5 1100,000 0.05H (1) H5 160,000 0.05A (2) A5 1190,000 0.20H (3) where R denotes the total cost of the Patient Records Department H denotes the total cost of the Human Resources Department A denotes the total cost of the Administration and Accounting Department

Service Department Direct-Patient-Care Department

Human

Resources

Administration

and Accounting Patient Records Orthopedics

Internal

Medicine

Costs prior to allocation ................................. $60,000 $190,000 $100,000

Allocation of Human Resources

Department costs ....................................... $60,000 12,000 (20/100)† 3,000 (5/100) $ 15,000 (25/100) $ 30,000 (50/100)

Allocation of Administration and

)59/06( *975,721)59/53( *124,47 000,202$................................................... stsoc tnemtrapeD gnitnuoccA

Allocation of Patient Records

Department costs .......................................................................................................... $103,000 30,900 (30/100) 72,100 (70/100)

Total cost allocated to

each department ............................................................................................................................................. $120,321 $229,679

Total cost allocated

to direct-patient-care departments ..................................................................................................................................... $350,000

* Rounded.

† Fractions in parentheses are relative proportions of service department’s output consumed by departments to which costs are allocated.

⎧ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎩

Exhibit 15–4Step-Down Method of Service

Department Cost Allocation:

Riverside Clinic

RIVERSIDE

CLINIC


Allocate service department

costs using the reciprocal-

services method.

RIVERSIDE

CLINIC


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Equation (1) says that the total cost of operating the Patient Records Department ( R ) is $100,000 plus 5 percent of the total cost of operating the Human Resources Depart-ment ( H ). The $100,000 comes from Exhibit 15–2 (panel C) and is the total cost trace-able to the Patient Records Department. We add to this amount 5 percent of the total cost of operating the Human Resources Department. Why? Because Exhibit 15–2 (panel A) tells us that the Patient Records Department used 5 percent of the Human Resources Department’s services. Similar explanations underlie equations (2) and (3).

The second step in the reciprocal-services method is to solve the simultaneous equations. 2 Let’s begin by substituting the expression for A from equation (3) into equation (2), and solving for H as follows:

H5 1 1

5 1

60,000 0.05 (190,000 0.20H)

60,000 9,500 0.01H

0.99H

H

69,500

70,202 (rounded)

5

5

1

Then we substitute the value for H we just obtained into equation (3), and solve for A as follows:

A5 1

15

5

190,000 0.20H

190,000 (0.20)(70,202)

204,040 (rounded)

Now we can solve for R by substituting the value for H into equation (1) as follows:

R5 1

5 1

5

100,000 0.05H

100,000 (0.05)(70,202)

103,510 (rounded)

Now we have determined that H � 70,202, A � 204,040, and R � 103,510. Their sums add up to more than $350,000 because of cross-allocations.

The final step in the reciprocal-services method is to allocate the total cost of operating each service department ( R , H , and A ) to the various departments that use its services. For example, we will allocate the total cost of operating the Human Resources Department ( H ) among all four of Riverside Clinic’s other departments, because they all use services from Human Resources. This allocation is made in pro-portion to the use of Human Resources’ services by the other departments, as given in Exhibit 15–2 (panel A).

The allocations are shown in Exhibit 15–5. Focus on the second row of numbers, which refers to the Human Resources Department. The $70,202 shown in parentheses in the Human Resources column is that department’s total cost, as computed using the simultaneous equations. This $70,202 total cost is allocated as follows:

• 20 percent (or $14,040) to Administration and Accounting, because that department uses 20 percent of the Human Resources Department’s services

• 5 percent (or $3,510) to Patient Records, because that department uses 5 percent of the Human Resources Department’s services

• 25 percent (or $17,551) to Orthopedics, because that department uses 25 percent of the Human Resources Department’s services

• 50 percent (or $35,101) to Internal Medicine, because that department uses 50 percent of the Human Resources Department’s services.

A similar explanation underlies the Administration and Accounting row and the Patient Records row in Exhibit 15–5.


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The total costs allocated to Riverside Clinic’s two direct-patient-care departments are as follows: $120,018 to Orthopedics and $229,982 to Internal Medicine. Notice that these two amounts add up to $350,000, which is the total of the original traceable costs for the three service departments. Thus, all service department costs have been fully allocated.

The reciprocal-services method is more accurate than the direct and step-down methods, because it fully accounts for reciprocal services. To make the reciprocal-services method even more accurate, it can be combined with the dual-allocation approach, dis-cussed a little later in this chapter.

Fixed versus Variable Costs In our allocation of Riverside Clinic’s service department costs, we did not distinguish between fixed and variable costs. Under some circumstances, this simple approach can result in an unfair cost allocation among the using departments. To illustrate, we will use the data about Riverside Clinic’s fixed and variable costs given in panel C of Exhibit 15–2. Consider the cost data for the Patient Records Department, which serves only the Ortho-pedics and Internal Medicine departments. Under the direct method of service department cost allocation, the Patient Records Department’s costs were allocated as follows:


Human

ResourcesAdministration

and AccountingPatient Records Orthopedics

Internal Medicine

Traceable costs ................................... $60,000 $190,000 $100,000


Department costs ........................... (70,202) 14,040*(0.20) 3,510*(0.05) $ 17,551*(0.25) $ 35,101 (0.50)


Accounting Department costs .......... 10,202 (0.05)† (204,040) –0– (0) 71,414 (0.35) 122,424 (0.60)


Department costs ........................... –0– (0) –0– (0) (103,510) 31,053 (0.30) 72,457 (0.70)

Total cost allocated to each

direct-patient-care department ............................................................................................................................. $120,018 $229,982

Total costs allocated ........................................................................................................................................................................... $350,000

*Rounded.

†Percentages in parentheses are relative proportions of a service department’s output consumed by departments to which costs are allocated (from Exhibit 15–2, panel A).

Exhibit 15–5Reciprocal-Services Method

of Service Department Cost

Allocation: Riverside Clinic

RIVERSIDE

CLINIC

Patient Records Orthopedics

Cost Allocation for 20x1: Direct Method

($100,000)(3/10) = $30,000

Internal Medicine

($100,000)(7/10) = $70,000

Variable cost

Fixed cost

Total cost

$ 24,000

76,000

$100,000

. . . . . . . . . . . .

. . . . . . . . . . . .

. . . . . . . . . . . ..

..

The allocation base used in this cost allocation is the annual patient load in the Orthopedics and Internal Medicine departments. Let’s assume the following patient loads in 20x1, the year for which the cost allocation has been done:


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Department Patient Load Proportion of Total

Orthopedics ....................................................... 30,000 .......................................... (30,000/100,000) � 3/10

Internal Medicine ............................................... 70,000 .......................................... (70,000/100,000) � 7/10

Total .................................................................. 100,000

Now suppose the projections for 20x2 are as follows:

Department Projected Patient Load Projected Proportion of Total

Orthopedics ....................................................... 30,000 .......................................... (30,000/80,000) � 3/8

Internal Medicine ............................................... 50,000 .......................................... (50,000/80,000) � 5/8

Total .................................................................. 80,000

Department Budgeted Variable Cost Budgeted Fixed Cost Budgeted Total Cost

Patient Records ................... $19,200 .................................... $76,000 .................................... $95,200

The projections for 20x2 include a stable patient load in the Orthopedics Depart-ment but a decline in the patient load of the Internal Medicine Department. Since the projected total patient load is lower for 20x2, the projected variable cost in the Patient Records Department is lower also.

What will be the effect of these changes on the 20x2 allocation of the Patient Records Department’s costs? Using the direct method, we obtain the following allocation:

Patient Records Orthopedics

Cost Allocation for 20x2: Direct Method

($95,200)(3/8) = $35,700

Internal Medicine

($95,200)(5/8) = $59,500

Variable cost

Fixed cost

Total cost

$ 19,200

76,000

$ 95,200

. . . . . . . . . . . .

. . . . . . . . . . . .

. . . . . . . . . . . ..

..

Compare the costs allocated to the two direct-patient-care departments in 20x1 and 20x2. Notice that the cost allocated to the Orthopedics Department increased by $5,700 (from $30,000 to $35,700), even though Orthopedics’ patient load is projected to remain constant. What has happened here? The projected decline in the Internal Medi-cine Department’s volume resulted in lower budgeted variable costs for the Patient Records Department, but the budgeted fixed costs did not change. At the same time, the lower projected patient load in Internal Medicine resulted in a higher proportion of the total projected patient load for Orthopedics (from 3/10 in 20x1 up to 3/8 in 20x2). As the following analysis shows, this results in an increased allocation of fixed costs to the Orthopedics Department in 20x2.

20x1 20x2

Fixed cost in Patient Records Department ..................................................................... $76,000 $76,000

Orthopedics Department’s proportion of total patient load .............................................. � 3/10 � 3/8

Orthopedics Department’s allocation of fixed cost ......................................................... $22,800 $28,500

Difference � $5,700


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This difference of $5,700 is equal to the increase in the Orthopedics Department’s total cost allocation from the Patient Records Department in 20x2.

To summarize, the projected decline in Internal Medicine’s 20x2 patient load will result in an increased cost allocation from the Patient Records Department to the Ortho-pedics Department in 20x2. The cause of this increased allocation is our failure to distin-guish between fixed and variable costs in the allocation process.

Dual Cost Allocation The problem illustrated in the preceding section can be resolved by allocating fixed and variable costs separately. This approach is called dual cost allocation . Under dual cost allocation, variable costs are allocated on the basis of short-run usage of the service department’s output; fixed costs are allocated on the basis of long-run average usage of the service department’s output. The rationale for this approach is that fixed costs are capacity-producing costs. When service departments are established, their size and scale usually are determined by the projected long-run needs of the using departments.

To illustrate dual cost allocation for Riverside Clinic, we need estimates of the long-run average usage of each service department’s output by each using department. These estimates are given in Exhibit 15–6.

To combine the dual-allocation approach with either the direct method or the step-down method, we simply apply the allocation method twice, as follows:

Costs to Be Allocated Basis for Allocation Allocation Method

Variable costs in 20x1

(Exhibit 15–2, panel C)

Short-run usage in 20x1

(Exhibit 15–2, panel A)

Direct

method

Step-down

method

or

Fixed costs in 20x1

(Exhibit 15–2, panel C)

Long-run average usage

(Exhibit 15–6)

Direct

method

Step-down

method

After both of these allocation procedures have been completed, the resulting vari-able and fixed-cost allocations for each direct-patient-care department are summed. Exhibit 15–7 presents the allocation computations when the dual approach is combined with the direct method. Compare the final direct allocations with those in Exhibit 15–3, where the dual approach was not used. Notice that the final allocations are different. Exhibit 15–8 presents the computations for the step-down method. Compare the final step-down allocations with those in Exhibit 15–4, where the dual approach was not used. Again, the final allocations are different.

A Behavioural Problem Dual cost allocation prevents a change in the short-run activity of one using department from affecting the cost allocated to another using department. However, the approach sometimes presents a problem of its own. In order to implement the technique, we need accurate projections of the long-run average usage of each service department’s output by each using department. This is the information in Exhibit 15–6.


Use the dual approach to

service department cost

allocation.

Provider of Service

User of ServicePatient Records

Human

ResourcesAdministration

and Accounting

Patient Records ..................................... — 10% —

Service departments Human Resources .................................. — — 10%

Administration and Accounting ................ — 10% —

Direct-patient-care

departments

Orthopedics ........................................... 40% 20% 45%

Internal Medicine ................................... 60% 60% 45%

Exhibit 15–6Provision of Services by

Service Departments:

Long-Run Average Usage,

Riverside Clinic

RIVERSIDE

CLINIC

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Direct-Patient-Care Department Using Services

Orthopedics Internal Medicine

Provider of Service Cost to Be Allocated Proportion Amount Proportion Amount

I. Variable Costs

Patient Records ................................ $ 24,000 3/10 $ 7,200 7/10 $ 16,800

Human Resources ............................. 15,000 25/75 5,000 50/75 10,000

Administration and Accounting ........... 47,500 35/95 17,500 60/95 30,000

Total variable cost .............................. $ 86,500 $ 29,700 $ 56,800

II. Fixed Costs

Patient Records ................................ $ 76,000 4/10 $ 30,400 6/10 $ 45,600

Human Resources ............................. 45,000 20/80 11,250 60/80 33,750

Administration and Accounting ........... 142,500 45/90 71,250 45/90 71,250

Total fixed cost .................................. $263,500 $112,900 $150,600

Total cost (variable � fixed) ............... $350,000 $142,600 $207,400

Grand total � $350,000

Exhibit 15–7Dual Allocation Combined

with Direct Method:

Riverside Clinic

Exhibit 15–8Dual Allocation Combined

with Step-Down Method:

Riverside Clinic

RIVERSIDE

CLINIC

RIVERSIDE

CLINIC


Human

Resources

Administration

and Accounting

Patient

Records Orthopedics

Internal

Medicine

I. Variable Costs

Variable cost prior to allocation ............... $15,000 $ 47,500 $ 24,000


Department costs .............................. $15,000 3,000 (20/100)† 750 (5/100) $ 3,750 (25/100) $ 7,500 (50/100)

Allocation of Administration

and Accounting Department costs ...... $ 50,500 18,605* (35/95) 31,895* (60/95)


Department costs .............................. $ 24,750 7,425 (30/100) 17,325 (70/100)

Total variable cost allocated

to each department ........................... $ 29,780 $ 56,720

II. Fixed Costs

Fixed cost prior to allocation ................... $45,000 $142,500 $ 76,000


Department costs .............................. $45,000 4,500 (10/100) 4,500 (10/100) $ 9,000 (20/100) $ 27,000 (60/100)


Accounting Department costs ............. $147,000 73,500 (45/90) 73,500 (45/90)


Department costs .............................. $ 80,500 32,200 (40/100) 48,300 (60/100)

Total fixed cost allocated

to each department ........................... $ 114,700 $148,800

Total cost allocated to each

department (variable � fixed) ............. $ 144,480 $205,520

Grand total � $350,000

*Rounded.

†Fractions in parentheses are relative proportions of service department’s output consumed by departments to which costs are allocated. Variable costs allocated on basis of short-run pro-

portions. Fixed costs allocated on basis of long-run average proportions.


Pass 3rd


Typically, these estimates come from the managers of the departments that consume the services. The problem is that the higher a manager’s estimate of the department’s long-run average usage is, the greater the department’s allocation of fixed service department costs will be. This creates an incentive for using-department managers to understate their expected long-run service needs. Ultimately, such understatements can result in building service facilities that are too small.

How can we prevent this behavioural problem? First, we can rely on the profession-alism and integrity of the managers who provide the estimates. Second, we can reward managers through promotions and pay raises for making accurate estimates of their departments’ service needs.

Allocate Budgeted Costs When service department costs are allocated to production departments, such as the direct-patient-care departments of Riverside Clinic, budgeted service department costs should be used. If actual costs are allocated instead, any operating inefficiencies in the service departments are passed along to the using departments. This reduces the incen-tive for service department managers to control the costs in their departments. The proper approach is as follows:

1. Compare budgeted and actual service department costs and compute any variances.

2. Use these variances to help control costs in the service departments. 3. Close out the service department cost variances against the period’s income. 4. Allocate the service departments’ budgeted costs to the departments that

directly produce goods or services.

Today’s Advanced Manufacturing Environment

In traditional manufacturing environments, service department costs are allocated to production departments to ensure that all manufacturing costs are assigned to products. For example, the costs incurred in a machine-maintenance department typically are allocated to the other service departments and the production departments that use maintenance services. Service department cost allocation continues to be used in the new manufacturing environment, characterized by the JIT philosophy and computer-integrated-manufacturing (CIM) systems. However, the extent of such allocations is diminished in advanced manufacturing systems, because more costs are directly trace-able to product lines. In a flexible manufacturing system (FMS), almost all operations are performed in the FMS cell. Even machine maintenance is done largely by the FMS cell operators rather than a separate maintenance department. Inspection is often per-formed by FMS cell operators, eliminating the need for a separate inspection depart-ment. In short, as more and more costs become directly traceable to products, the need for allocation of indirect costs declines.

The Rise of Activity-Based Costing Service department cost allocation is one type of allocation procedure used in two-stage allocation with departmental overhead rates. Under this approach, costs first are distrib-uted to departments and then they are allocated from service departments to production departments . Finally, they are assigned from production departments to products or ser-vices. Departments play a key role as intermediate cost objects in this approach.

In an activity-based costing (ABC) system, on the other hand, the key role is played by activities , not departments. First, the costs of various activities are assigned to activity cost pools and then these costs are assigned to products or services.


Explain the difference between

two-stage cost allocation with

departmental overhead rates and

activity-based costing (ABC).


Pass 3rd


The breakdown of costs by activity in an ABC system is much finer than a breakdown by departments. For example, in the service department cost allocation approach, the Pur-chasing Department might be one of the service departments identified. However, under ABC, the various activities engaged in by purchasing personnel would be separately identi-fied. Activities such as part specification, vendor identification, vendor selection, price nego-tiation, ordering, expediting, receiving, inspection, and invoice paying might be identified separately under ABC. Then the costs of each of these activities would be assigned to prod-ucts or services on the basis of the appropriate cost drivers. The ABC approach generally will provide a much more accurate cost for each of the organization’s products or services.

Joint Product Cost Allocation

A joint production process results in two or more products, which are termed joint products . The cost of the input and the joint production process is called a joint product cost . The point in the production process where the individual products become sepa-rately identifiable is called the split-off point .


Allocate joint costs among joint

products using each of the

following techniques:

physical-units method,

relative-sales-value method, and

net-realizable-value method.

Milk processing provides an example of joint product cost allocation in the agriculture industry. The cost of producing raw milk must be allocated among such joint products as heavy cream, light cream, whole milk, 2 percent milk, and skim milk.

To illustrate, the International Chocolate Company produces cocoa powder and cocoa butter by processing cocoa beans in the joint production process depicted in Exhibit 15–9. As the diagram shows, cocoa beans are processed in 1-tonne batches. The beans cost $500 and the joint process costs $600, for a total joint cost of $1,100. The process results in

Cocoa beanscosting $500per 1-tonne batch

Total joint cost:$1,100 per 1-tonne batch

Split-off point

Joint productionprocess costing$600 per tonne

Cocoa buttersales value:$750 for1,500 kilograms

Cocoa powdersales value:$500 for500 kilograms

Separableprocesscosting$800

Instant cocoa mixsales value:$2,000 for500 kilograms

CocoaBeans

Separableprocesscosting$1,560

Sunscreensales value:$3,000 for1,500 kilograms

Exhibit 15–9Joint Processing of Cocoa Beans: International Chocolate Company


Pass 3rd


1,500 kilograms of cocoa butter and 500 kilograms of cocoa powder. Each of these two joint products can be sold at the split-off point or processed further. Cocoa butter can be separately processed into sunscreen, and cocoa powder can be separately processed into instant cocoa mix.

Allocating Joint Costs For product-costing purposes, a joint product cost usually is allocated to the joint prod-ucts that result from the joint production process. Such allocation is necessary for inven-tory valuation and income determination, among other reasons. As we discussed in Chapter 12, however, joint cost allocation is not useful for making substantive economic decisions about the joint process or the joint products. For example, Chapter 12 shows that joint cost allocation is not useful in deciding whether to process a joint product further. (See the section entitled “Joint Products: Sell or Process Further.”) There are three commonly used methods for allocating joint product costs. Each of these is explained next.

Physical-Units Method The physical-units method allocates joint product costs on the basis of some physical characteristic of the joint products at the split-off point. Panel A of Exhibit 15–10 illustrates this allocation method for the International Chocolate Com-pany using the weight of the joint products as the allocation basis.

Relative-Sales-Value Method The relative-sales-value method is based on the relative sales value of each joint product at the split-off point . In the International Chocolate


Describe the purposes for

which joint cost allocation is

useful and those for which

it is not.

A. Physical-Units Method

Joint Cost Joint Products Weight at Split-off Point

Relative

Proportion

Allocation of

Joint Cost

$1,100

Cocoa butter .............................................. 1,500 kilograms ................. 3/4 ........... $ 825

Cocoa powder ........................................... 500 kilograms ................. 1/4 ........... 275

Total joint cost allocated ........................................................................................................ $1,100

B. Relative-Sales-Value Method

Joint Cost Joint Products

Sales Value at

Split-off Point

Relative

Proportion

Allocation of

Joint Cost

$1,100

Cocoa butter ................................................. $750 ......................... 3/5 ................ $ 660

Cocoa powder .............................................. 500 ......................... 2/5 ................ 440

Total joint cost allocated ....................................................................................................... $1,100

*Sales value of

fi nal product�

Incremental cost

of processing�

Net realizable

value †Calculation of relative proportions:

$3,000 � $1,560 � $1,440 $1,440 � $1,200 � $2,640

2,000 � 800 � 1,200 1,440 � 2,640 � 6/11

1,200 � 2,640 � 5/11

C. Net-Realizable-Value Method

Joint Cost Joint Products

Sales Value

of Final

Product

Separable

Cost of

Processing

Net

Realizable

Value

Relative

Proportion

Allocation

of Joint

Cost

Sunscreen .................. $3,000 .......... $1,560 .......... $1,440* .......... 6/11† . ....... $ 600

$1,100 Instant cocoa mix ....... 2,000 .......... 800 .......... 1,200* .......... 5/11† ........ 500

Total joint cost allocated ....................................................................................................... $1,100

Exhibit 15–10Methods for Allocating Joint

Product Costs


Pass 3rd


Company example, these joint products are cocoa butter and cocoa powder. This method is illustrated in panel B of Exhibit 15–10

Net-Realizable-Value Method Under the net-realizable-value method , the relative value of the final products is used to allocate the joint cost. International Chocolate Company’s final products are sunscreen and instant cocoa mix. The net realizable value of each final product is its sales value less any separable costs incurred after the split-off point. The joint cost is allocated according to the relative magnitudes of the final products’ net realizable values. Panel C of Exhibit 15–10 illustrates this alloca-tion method.

Notice how different the cost allocations are under the three methods, particularly the physical-units method. Since the physical-units approach is not based on the eco-nomic characteristics of the joint products, it is the least preferred of the three methods.

By-Products A joint product with very little value relative to the other joint products is termed a by-product . For example, whey is a by-product in the production of cheese. A common practice in accounting is to subtract a by-product’s net realizable value from the cost of the joint process. Then the remaining joint cost is allocated among the major joint products.

An alternative procedure is to inventory the by-product at its sales value at split-off. Then the by-product’s sales value is deducted from the production cost of the main products.

“Joint costing problems

crop up more often than you

might think. They’re among

the thornier [cost manage-

ment] issues our clients

have to deal with.” (15c)

A. T. Kearney

JOINT COST ALLOCATION IN THE PETROLEUM INDUSTRY

One of the most complicated problems in joint cost allocation routinely occurs in the petroleum industry. When an oil com-pany, such as Petro-Canada, drills a successful oil well, the well almost always produces natural gas in addition to crude oil. Moreover, the crude oil produced by a typical oil well is of

various grades. Lighter crude oils suitable for production of such products as gasoline are generally near the top of an oil reservoir, while the heavier crudes are near the bottom. The heavier crude oils are used to make such products as fuel oil for heating homes and businesses and for the generation of electricity. All of these products obtained from a successful oil well are joint products: the various grades of crude oil and the natural gas. Most of these products will require further pro-cessing before they will be saleable products such as gasoline, diesel fuel, or home heat-ing oil. This means that substantial separable costs will be incurred in processing the joint products in addition to the joint costs incurred in the oil field operations. Millions of dollars of joint costs are incurred in the development of an offshore oil field. The costs of locating the oil field, building the drilling platforms, and the drilling itself are all joint costs. Then there are the costs of crewing the oil rigs and the ongoing costs of bringing oil and natural gas to the surface. Oil companies such as Petro-Canada typically use the net realizable value of the products manufactured as the basis for allocating the joint production costs. The full costs of the company’s various products then become the basis for pricing and product-mix decisions. The next time you pump gas for your automobile, think about the salaries of the heli-copter pilots who bring food and other supplies to the many offshore oil platforms. Those costs make up part of the joint cost allocated to the gasoline you obtain from the pump.

Petro-Canada

M

A

P

anagerial

ccounting

ractice


Pass 3rd


LO1 Allocate service department costs using the direct method and the step-down method. Under the direct method, the costs of each service department are allocated directly to each production department in proportion to each production department’s usage of each service department’s output. Under the step-down method, the service departments are first ranked by the number of other service departments that each one serves. Then the costs of each service department in the ranked sequence are allocated among all of the remaining service departments in the sequence together with all of the production departments.

LO2 Allocate service department costs using the reciprocal-services method. Under the reciprocal- services method, simultaneous equations are specified to show how each service and production department uses the services of the various service departments. When these equations are solved simultaneously, the result is the amount of service department cost to be allocated to each production department. Unlike the direct and step-down methods, the reciprocal-services method fully accounts for all reciprocal services among service departments.

LO3 Use the dual approach to service department cost allocation. Either the direct or the step-down method may be combined with the dual-allocation approach, in which variable and fixed costs are allocated separately.

LO4 Explain the difference between two-stage cost allocation with departmental overhead rates and activity-based costing (ABC). Two-stage allocation with departmental overhead rates involves the following three steps: (1) All overhead costs are allocated among all service and production departments. (2) Service department costs are allocated to production departments. (3) Production department costs are applied to products or services. In contrast, two-stage allocation under ABC involves the following two steps: (1) Resource costs are assigned to activity cost pools. (2) The costs in these activity cost pools are assigned to cost objects (e.g., products or services) using appropriate cost drivers.

LO5 Allocate joint costs among joint products using each of the following techniques: physical-units method, relative-sales-value method, and net-realizable-value method. In the physical-units method, the joint cost is allocated to the joint products in proportion to some physical characteristic of the joint products, such as weight or volume. In the relative-sales-value method, the joint cost is allocated to the joint products in proportion to the joint products’ sales values at the split-off point. In the net-realizable-value method, the joint cost is allocated to the joint products in proportion to the joint products’ net realizable values.

LO6 Describe the purposes for which joint cost allocation is useful and those for which it is not. Joint cost allocation is useful for product-costing purposes, but the allocated costs should not affect substantive economic decisions.

Chapter Summary

Renaissance School of Music and Art provides classes for school-aged children. The students are enrolled in two departments: Music Education and Art Education. The school also has two service departments: Administration and Human Resources (A & HR) and Maintenance (M). The budgeted costs in the two service departments are as follows:

Administration and Human Resources ............................................................................................................ $342,000

Maintenance ................................................................................................................................................ 171,000

The usage of the service department’s output for the year is as follows:

Provider of Service

User of Service

Administration &

Human Resources Maintenance

Administration & Human Resources ................................................................... — 5%

Maintenance .................................................................................................... 10% —

Music Education ............................................................................................... 40% 40%

Art Education .................................................................................................... 50% 55%

Required: Allocate the two services departments’ costs to the Music Education and Art Education departments using each of the following allocation methods.

Review Problem on Service Departmental Cost Allocation


Pass 3rd


1. Direct method 2. Step-down method (Since each service department serves one other service department, allocate the

cost of A & HR first.)

Solution to Review Problem

1. Cost allocation using direct method:

Departments Using Services

Music Education Art Education

Provider of Service

Cost to Be

Allocated Proportion Amount Proportion Amount

A & HR .............................. $342,000 (4/9) $152,000 (5/9) $190,000

M ..................................... 171,000 (40/95) 72,000 (55/95) 99,000

Total ................................. $513,000 $224,000 $289,000

2. Cost allocation using step-down method:

Service Departments Departments Using Services

A&HR M Music Education Art Education

Costs prior to allocation .............................. $342,000 $171,000

Allocation of A & HR

costs ....................................................... $342,000 34,200 (10%) $136,800 (40%) $171,000 (50%)

Allocation of M

costs ....................................................... $205,200 6,400 (40/95) 118,800 (55/95)

Total costs allocated to

each department ..................................... $223,200 $289,800

Total cost allocated to

academic departments ............................. $513,000

Review key terms and definitions on Connect.

Glossary

15–1. Distinguish between a service department and a produc-tion department. Give an example of the counterpart of a manufacturer’s “production department” in a bank.

15–2. Define the term reciprocal services . 15–3. Explain briefly the main differences between the direct,

step-down, and reciprocal-services methods of service department cost allocation.

15–4. How does the management accountant determine the department sequence in the step-down method? How are ties handled?

15–5. Why does the dual-allocation approach improve the resulting cost allocation?

15–6. What potential behavioural problem can result when the dual approach is used?

15–7. Should actual or budgeted service department costs be allocated? Why?

15–8. Explain the difference between two-stage allocation with departmental overhead rates and activity-based costing. Which approach generally results in more accurate prod-uct costs?

15–9. Define the following terms: joint production process , joint costs , joint products , split-off point , incremental costs , and by-product .

15–10. Briefly explain how to use the physical-units method of joint cost allocation.

15–11. Describe the relative-sales-value method of joint cost allocation.

15–12. Define the term net realizable value , and explain how this concept can be used to allocate joint costs.

15–13. Are joint cost allocations useful? If they are, for what purpose? 15–14. For what purpose should the management accountant be

careful not to use joint cost allocations?

Review Questions


Pass 3rd


Exercise 15–15 Direct Method of Service Department Cost Allocation: College (LO1) Victoria Community College enrols students in two departments, Liberal Arts and Sciences. The college also has two service departments, the Library and the Computing Services Department. The usage of these two service departments’ output for the year is as follows:

Provider of Service

User of Service Library Computing Services

Library ..................................................................................................... — 20%

Computing Services .................................................................................. — —

Liberal Arts ............................................................................................... 60% 30%

Sciences .................................................................................................. 40% 50%

The budgeted costs in the two service departments for the year are as follows:

Library ................................................................................................................................................. $600,000

Computing Services .............................................................................................................................. 240,000

Required:

1. Use the direct method to allocate the budgeted costs of the Library and Computing Services Depart-ment to the college’s Liberal Arts and Sciences departments.

2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show how the solution will change if the following information changes: The budgeted costs of the Library and Computing Services are $590,000 and $280,000, respectively.

Exercise 15–16 Step-Down Method of Service Department Cost Allocation: College (LO1) Refer to the data given in the preceding exercise.

Required:

1. Use the step-down method to allocate Victoria Community College’s service department costs to the Liberal Arts and Sciences departments.

2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show how the solution will change if the following information changes: The budgeted costs of the Library and Computing Services are $590,000 and $280,000, respectively.

Exercise 15–17 Direct Method of Service Department Cost Allocation: Bank (LO1) Fraser Bank has two service departments, the Human Resources (HR) Department and the Computing Department. The bank has two other departments that directly service customers, the Deposit Department and the Loan Department. The usage of the two service departments’ output for the year is as follows:

Provider of Service

User of Service HR Computing

HR ............................................................................................................................ — 15%

Computing ............................................................................................................... 10% —

Deposit .................................................................................................................... 60% 50%

Loan ........................................................................................................................ 30% 35%

The budgeted costs in the two service departments for the year are as follows:

HR ................................................................................................................................................... $153,000

Computing ....................................................................................................................................... 229,500

Required: Use the direct method to allocate the budgeted costs of the HR and Computing departments to the Deposit and Loan departments.

Exercises


Pass 3rd


Exercise 15–18 Step-Down Method of Service Department Cost Allocation: Bank (LO1) Refer to the data given in the preceding exercise.

Required: Use the step-down method to allocate the budgeted costs of the HR and Computing departments to the Deposit and Loan departments. Fraser Bank allocates the costs of the HR Department first.

Exercise 15–19 Reciprocal-Services Method: Bank (LO2) Refer to the data given in Exercise 15–17.

Required: Use the reciprocal-services method to allocate the budgeted costs of the HR and Computing departments to the Deposit and Loan departments. (Round your final answer to nearest dollar.)

Exercise 15–20 Service Department Cost Allocation; Use of the Internet (LO1) Visit the website of one of the following organizations, or a different organization of your choice:

Manulife Financial www.manulife.ca Mission Hill Winery www.missionhillwinery.com McGill University Health Centre www.muhc.ca Sheraton Hotels & Resorts www.sheraton.com Walt Disney Studios www.disney.com

Required: Read about the organization’s activities and operations. Then list three activities that you think the organization would need that would likely be established as service departments. For what purposes would it be relevant to allocate those service department costs to nonservice departments within the organization?

Exercise 15–21 Physical-Units Method; Joint Cost Allocation (LO5) Breakfasttime Cereal Company manufactures two breakfast cereals in a joint process. Cost and quantity information is as follows:

Joint Cost Cereal Quantity at Split-Off Point Sales Price per Kilogram

$30,000Yummies ................................ 12,000 kilograms ................................. $2.00

Crummies ............................... 8,000 kilograms ................................. 2.50

Required: Use the physical-units method to allocate the company’s joint production cost between Yummies and Crummies.

Exercise 15–22 Relative-Sales-Value Method; Joint Cost Allocation (LO5) Refer to the data given in the preceding exercise.

Required: Use the relative-sales-value method to allocate Breakfasttime Cereal Company’s joint production cost between Yummies and Crummies. (Round proportion of sales value to three decimal places.)

Exercise 15–23 Net-Realizable-Value Method; Joint Cost Allocation (LO5) Refer to the data given in Exercise 15–21. Breakfasttime Cereal Company has an opportunity to process its Crummies further into Munchies. The additional processing operation costs $0.50 per kilogram, and the Munchies will sell for $3.50 per kilogram. The quantities of Munchies will be the same as that of the Crummies.

Required:

1. Should Breakfasttime’s management decide to process Crummies into Munchies? Why? 2. Suppose the company does process Crummies into Munchies. Use the net-realizable-value method to

allocate the joint production cost between the Munchies and the Yummies.


Pass 3rd


Problems

Problem 15–24 Direct and Step-Down Methods of Service Department Cost Allocation (LO1) York Instrument Company manufactures gauges for construction machinery. The company has two produc-tion departments: Machining and Finishing. There are three service departments: Maintenance, Human Resources (HR), and Design. The budgeted costs in York Instrument Company’s service departments during the year are as follows:

HR Maintenance Design

Variable .......................................................................... $ 50,000 $ 80,000 $ 50,000

Fixed .............................................................................. 200,000 150,000 300,000

Total .............................................................................. $250,000 $230,000 $350,000

The usage of these service departments’ output during the year just completed is as follows:

Provision of Service Output (in hours of service)

Provider of Service

User of Service HR Maintenance Design

HR ..................................................................................... — — —

Maintenance ...................................................................... 500 — —

Design ............................................................................... 500 500 —

Machining .......................................................................... 4,000 3,500 4,500

Finishing ............................................................................ 5,000 4,000 1,500

Total ................................................................................... 10,000 8,000 6,000

Required:

1. Use the direct method to allocate York Instrument Company’s service department costs to its produc-tion departments. (Round your final answer to the nearest dollar.)

2. Determine the proper sequence to use in allocating the firm’s service department costs by the step-down method.

3. Use the step-down method to allocate the company’s service department costs. (Round your final an-swer to the nearest dollar.)

4. Build a spreadsheet : Construct an Excel spreadsheet to solve requirements (1) and (3) above. Show how the solution will change if the following information changes: The budgeted variable costs in the three departments are $60,000, $70,000, and $55,000, for Human Resources, Maintenance, and De-sign, respectively.

Problem 15–25 Dual Allocation of Service Department Costs (LO1, 3) Refer to the data given in the preceding problem. When York Instrument Company established its service departments, the following long-run needs were anticipated.

Long-Run Service Needs (in hours of service)

Provider of Service

User of Service HR Maintenance Design

HR ................................................................................... — — —

Maintenance .................................................................... 500 — —

Design ............................................................................. 1,000 800 —

Machining ......................................................................... 3,500 4,800 4,800

Finishing .......................................................................... 5,000 2,400 1,200

Total ................................................................................. 10,000 8,000 6,000

1. HR department cost

allocated to Finishing:

$138,889

3. HR department cost

allocated to Design: $12,500

1(a). Variable costs, Design,

allocated to Machining:

$37,500

1(b). Fixed costs, HR

Department, allocated to

Finishing: $117,647


Pass 3rd


Required: Use the dual approach in conjunction with each of the following methods to allocate York Instrument Company’s service department costs: (1) direct method and (2) step-down method. Hint: First, allocate the three service departments’ variable costs using the short-run usage proportions. Second, allocate the three service departments’ fixed costs using the long-run average usage proportions. Finally, add the variable costs and fixed costs allocated to each production department.

Problem 15–26 Service Department Cost Allocation (LO1) Celestial Artistry Company is developing departmental overhead rates based on direct-labour hours for its two production departments, Etching and Finishing. The Etching Department employs 20 people and the Finishing Department employs 80 people. Each person in these two departments works 2,000 hours per year. The production-related overhead costs for the Etching Department are budgeted at $200,000, and the Finishing Department costs are budgeted at $320,000. Two service departments, Maintenance and Computing, directly support the two production departments. These service depart-ments have budgeted costs of $48,000 and $250,000, respectively. The production departments’ over-head rates cannot be determined until the service departments’ costs are allocated. The following schedule reflects the use of the Maintenance Department’s and Computing Department’s output by the various departments.

Using Department

Service Department Maintenance Computing Etching Finishing

Maintenance (maintenance hours) ................ 0 1,000 1,000 8,000

Computing (minutes) ..................................... 240,000 0 840,000 120,000

Required:

1. Calculate the overhead rates per direct-labour hour for the Etching Department and the Finishing Department. Use the direct method to allocate service department costs.

2. Calculate the overhead rates per direct-labour hour for the Etching Department and the Finishing Department. Use the step-down method to allocate service department costs. Allocate the Computing Department’s costs first.

(CMA, adapted)

Problem 15–27 Reciprocal-Service Method (LO2) Refer to the data given in the preceding problem.

Required:

1. Calculate the overhead rates per direct-labour hour for the Etching Department and the Finishing Department. Use the reciprocal-services method to allocate service department costs.

2. Which of the three methods of service department cost allocation results in the most accurate over-head rates? Why?

Problem 15–28 Reciprocal-Services Method; Dual Allocation (LO2, 3) Refer to the data for Riverside Clinic given in Exhibits 15–2 and 15–6.

Required: Use the reciprocal-services method in combination with the dual-allocation approach to allocate Riverside’s service department costs. Hint: You will need to apply the reciprocal-services method twice. First, allocate the three service departments’ variable costs using the short-run usage proportions in Exhibit 15–2 (panel A). Second, allocate the three service departments’ fixed costs using the long-run average usage proportions in Exhibit 15–6. Finally, add the variable costs and fixed costs allocated to each direct-patient-care department.

Problem 15–29 Service Department Cost Allocation; Plantwide versus Departmental Overhead Rates;

Cost Drivers (LO1, 2) Travelcraft, Inc. manufactures a complete line of fibreglass suitcases and attaché cases. The firm has three manufacturing departments: Moulding, Component, and Assembly. There are also two service departments: Power and Maintenance. The sides of the cases are manufactured in the Moulding Department. The frames, hinges, and locks are manufactured in the Component Department. The cases are completed in the Assembly Department.

1. Overhead rate per hour,

Etching: $10.602 (rounded)

2. Maintenance Department

costs allocated to Finishing:

$87,111

M � $100,000, where M

denotes the “total” cost of the

Maintenance Department;

Total service department

costs allocated to Etching:

$192,000

1. Variable costs: H � $17,551 (rounded), where H

denotes the “total” cost of the

HR Department;

Total variable cost allocated to

Orthopedics: $29,705

2. H � $59,848 (rounded),

where H denotes the “total”

cost of the HR Department;

Total fixed cost allocated to

Internal Medicine: $151,918

1. Plantwide overhead rate:

$20.55 per direct-labour hour

2(c). Rate, Moulding: $37.44

per MH

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Pass 3rd


Varying amounts of materials, time, and effort are required for each of the cases. The Power Department and Maintenance Department provide services to the three manufacturing departments. Travelcraft has always used a plantwide overhead rate. Direct-labour hours are used to assign overhead to products. The predetermined overhead rate is calculated by dividing the company’s total estimated over-head by the total estimated direct-labour hours to be worked in the three manufacturing departments. Karen Mason, director of cost management, has recommended that Travelcraft use departmental overhead rates. The planned operating costs and expected levels of activity for the coming year have been developed by Mason and are presented by department in the following schedules. (All numbers are in thousands.)

Manufacturing Departments

Moulding Component Assembly

Department activity measures:

Direct-labour hours .......................................................................... 500 2,000 1,500

Machine hours ................................................................................ 875 125 –0–

Departmental costs:

Direct material ................................................................................. $12,400 $30,000 $ 1,250

Direct labour ................................................................................... 3,500 20,000 12,000

Variable overhead ............................................................................ 3,500 10,000 16,500

Fixed overhead ................................................................................ 17,500 6,200 6,100

Total departmental costs .................................................................. $36,900 $66,200 $35,850

Use of service departments:

Maintenance:

Estimated usage in labour hours

for the coming year .............................................................. 90 25 10

Power (in kilowatt-hours):

Estimated usage for the coming year ............................................ 360 320 120

Maximum allotted capacity .......................................................... 500 350 150

Service Departments

Power Maintenance

Departmental activity measures:

Maximum capacity ............................................................................ 1,000 kWh Adjustable

Estimated usage for the coming year ................................................. 800 kWh 125 hours

Departmental costs:

Materials and supplies ...................................................................... $ 5,000 $1,500

Variable labour .................................................................................. 1,400 2,250

Fixed overhead ................................................................................. 12,000 250

Total service department costs ........................................................... $18,400 $4,000

Required:

1. Calculate the plantwide overhead rate for Travelcraft Company for the coming year using the same method as used in the past.

2. Karen Mason has been asked to develop departmental overhead rates for comparison with the plantwide rate. The following steps are to be followed in developing the departmental rates:

a. The Maintenance Department costs should be allocated to the three manufacturing departments using the direct method.

b. The Power Department costs should be allocated to the three manufacturing departments using the dual method combined with the direct method. Fixed costs are to be allocated according to maximum allotted capacity, and variable costs are to be allocated according to planned usage for the coming year.


Pass 3rd


c. Calculate departmental overhead rates for the three manufacturing departments using a machine-hour cost driver for the Moulding Department and a direct-labour-hour cost driver for the Com-ponent and Assembly departments.

3. As Karen Mason’s assistant, draft a memo for her to send to Travelcraft’s president recommending whether the company should use a plantwide rate or departmental rates to assign overhead to products.

(CMA, adapted)

Problem 15–30 Joint Costs; Allocation and Production Decisions (LO5, 6) Le Monde Company is a manufacturer of chemicals for various purposes. One of the processes used by Le Monde produces HTP-3, a chemical used in hot tubs and swimming pools; PST-4, a chemical used in pes-ticides; and RJ-5, a product that is sold to fertilizer manufacturers. Le Monde uses the net-realizable-value method to allocate joint production costs. The ratio of output quantities to input quantities of direct mate-rial used in the joint process remains consistent from month to month. Le Monde Company uses FIFO (first-in, first-out) in valuing its finished-goods inventories. Data regarding Le Monde’s operations for the month of October are shown below. During this month, Le Monde incurred joint production costs of $1,700,000 in the manufacture of HTP-3, PST-4, and RJ-5.

HTP-3 PST-4 RJ-5

Finished goods inventory in litres (October 1) ................................. 18,000 52,000 3,000

October sales in litres .................................................................... 650,000 325,000 150,000

October production in litres ............................................................ 700,000 350,000 170,000

Additional processing costs ........................................................... $874,000 $816,000 $60,000

Final sales value per litre ............................................................... $ 4 $ 6 $ 5

Required:

1. Determine Le Monde Company’s allocation of joint production costs for the month of October. (Carry calculation of relative proportions to four decimal places.)

2. Determine the dollar values of the finished-goods inventories for HTP-3, PST-4, and RJ-5 as of October 31. (Round the cost per litre to the nearest cent.)

3. Suppose Le Monde Company has a new opportunity to sell PST-4 at the split-off point for $3.80 per litre. Prepare an analysis showing whether the company should sell PST-4 at the split-off point or continue to process this product further.

(CMA, adapted)

Problem 15–31 Joint Cost Allocation; Missing Data (LO5) Gleed Company manufactures products Delta, Kappa, and Omega from a joint process. Production, sales, and cost data for July follow.

Delta Kappa Omega Total

Units produced ................................................................. 4,000 2,000 1,000 7,000

Joint cost allocation .......................................................... $36,000 ? ? $ 60,000

Sales value at split-off ....................................................... ? ? $15,000 $100,000

Additional costs if processed further ................................... $ 7,000 $ 5,000 $ 3,000 $ 15,000

Sales value if processed further ......................................... $70,000 $25,000 $20,000 $115,000

Required:

1. Assuming that joint costs are allocated using the relative-sales-value method, what were the joint costs allocated to products Kappa and Omega?

2. Assuming that joint costs are allocated using the relative-sales-value method, what was the sales value at split-off for product Delta?

3. Use the net-realizable-value method to allocate the joint production costs to the three products.

(CPA, adapted)

1. HTP-3, net realizable value:

$1,926,000

3. Additional processing costs

per litre: $2.33 (rounded)

1. Omega, joint cost

allocation: $9,000

3. Kappa, net realizable value:

$20,000


Pass 3rd


Problem 15–32 Joint Costs (LO5, 6) Snake River Sawmill manufactures two lumber products from a joint milling process. The two products developed are mine support braces (MSB) and unseasoned commercial building lumber (CBL). A standard production run incurs joint costs of $300,000 and results in 60,000 units of MSB and 90,000 units of CBL. Each MSB sells for $2 and each unit of CBL sells for $4.

Required:

1. Calculate the amount of joint cost allocated to commercial building lumber (CBL) on a physical-units basis.

2. Calculate the amount of joint cost allocated to the mine support braces (MSB) on a relative-sales-value basis.

3. Assume the commercial building lumber is not marketable at split-off but has to be further planed and sized at a cost of $200,000 per production run. During this process, 10,000 units are unavoidably lost; these spoiled units have no value. The remaining units of commercial building lumber are saleable at $10 per unit. The mine support braces, although saleable immediately at the split-off point, are coated with a tar-like preservative that costs $100,000 per production run. The braces are then sold for $5 each. Using the net-realizable-value basis, compute the completed cost assigned to each unit of com-mercial building lumber. (Round the cost per unit to the nearest cent.)

4. If Snake River Sawmill chose not to process the mine support braces beyond the split-off point, the contribution from the joint milling process would increase or decrease by what amount?

5. Did you use the joint cost allocation results in answering requirement (4)? If so, how? Why did you use or not use the allocation results?

(CMA, adapted)

Problem 15–33 Joint Products; Sell or Process Further (LO5, 6) Winchester Chemicals uses a joint process to produce VX-4, a chemical used in the manufacture of paints and varnishes; HD-10, a chemical used in household cleaning products; and FT-5, a by-product that is sold to fertilizer manufacturers. Joint production costs are allocated to the main products on the basis of net realizable value. The by-product is inventoried at its net realizable value, and this value is used to reduce the joint production cost before allocation to the main products. During the month of November, Winchester incurred joint production costs of $1,568,000. Data regarding Winchester’s November operations are as follows:

VX-4 HD-10 FT-5

November production in litres ........................................................... 600,000 320,000 85,000

Sales value per litre at split-off .......................................................... None $3.00 $0.90*

Incremental processing cost ............................................................. $720,000 $920,000 None

Final sales value per litre .................................................................. $4.00 $6.375 None

Finished-goods inventory in litres on

November 30 (all produced during November) ............................... 9,000 26,000 1,500

*Disposal costs of $0.10 per litre will be incurred in order to sell the by-product.

Required:

1. Define the terms joint costs and split-off point . 2. Determine the dollar values of Winchester Chemicals’ finished-goods inventories on November 30 for

VX-4 and HD-10. 3. Winchester Chemicals has an opportunity to sell HD-10 for its sales value at the split-off point.

Determine if Winchester should sell HD-10 at the split-off point or continue to process it further.

(CPA, adapted)

Problem 15–34 Joint Costs; Allocation and Production Decisions; Ethics (LO5, 6) Lafayette Company manufactures two products out of a joint process: Compod and Ultrasene. The joint costs incurred are $250,000 for a standard production run that generates 120,000 litres of Compod and 80,000 litres of Ultrasene. Compod sells for $2 per litre while Ultrasene sells for $3.25 per litre.

2. CBL, allocation of joint

cost: $225,000

3. MSB, net realizable value:

$200,000

2. Joint cost allocation, VX-4:

$900,000

3. Incremental revenue:

$160,000

1. Ultrasene, relative

proportion: 40%

3(b). Ultrasene, separable

cost of processing: $88,000


Pass 3rd


Required:

1. If there are no additional processing costs incurred after the split-off point, calculate the amount of joint cost of each production run allocated to Compod on a physical-units basis.

2. If there are no additional processing costs incurred after the split-off point, calculate the amount of joint cost of each production run allocated to Ultrasene on a relative-sales-value basis.

3. Suppose the following additional processing costs are required beyond the split-off point in order to obtain Compod and Ultrasene: $0.10 per litre for Compod and $1.10 per litre for Ultrasene.

a. Calculate the amount of joint cost of each production run allocated to Ultrasene on a physical-units basis.

b. Calculate the amount of joint cost of each production run allocated to Compod on a net- realizable-value basis.

4. Assuming the same data as in requirement (3), suppose Compod can be processed further into a prod-uct called Compodalene, at an additional cost of $0.40 per litre. Compodalene will be sold for $2.60 per litre by independent distributors. The distributors’ commission will be 10 percent of the sales price. Should Lafayette sell Compod or Compodalene?

5. Independent of your answer to requirement (4), suppose Christine Dalton, the assistant controller, has completed an analysis showing that Compod should not be processed further into Compodalene. Before presenting her analysis to top management, however, she got a visit from Jack Turner, Lafayette’s director of research. Turner was upset upon learning that Compodalene, a product he had personally developed, would not be manufactured.

Turner: The company’s making a big mistake if it passes up this opportunity. Compodalene will be a big seller and get us into new markets.

Dalton : But the analysis shows that we’d be losing money on every litre of Compod that we process further. Turner: I know, Christine, but that’s a temporary problem. Eventually, we’ll bring down the cost of

making Compodalene. Dalton : Can you find me some estimates on the cost reduction you expect? Turner: I don’t have a crystal ball, Christine. Look, if you could just fudge the numbers a little bit to

help me get approval to produce some Compodalene, I can get this product off the ground. I know the cost reduction will come.

Comment on the ethical issues in this scenario. What should Christine Dalton do?

6. Assume the same data as given in requirements (3) and (4). The industrial chemical industry has expe-rienced a downturn, which has left Lafayette with idle capacity. Suppose Lafayette can sell only half of the Compod made in each production run, but the remainder could be sold as Compodalene. Should Lafayette process the remaining Compod into Compodalene?

(CMA, adapted)

Cases

Case 15–35 Joint Cost Allocation; By-Product (LO5) Top Quality Fruit Company, based on Oahu, grows, processes, cans, and sells three main pineapple prod-ucts: sliced, crushed, and juice. The outside skin is cut off in the Cutting Department and processed as ani-mal feed. The feed is treated as a by-product. The company’s production process is as follows:

• Pineapples first are processed in the Cutting Department. The pineapples are washed and the outside skin is cut away. Then the pineapples are cored and trimmed for slicing. The three main products (sliced, crushed, juice) and the by-product (animal feed) are recognizable after processing in the Cut-ting Department. Each product then is transferred to a separate department for final processing.

• The trimmed pineapples are sent to the Slicing Department, where the pineapples are sliced and canned. Any juice generated during the slicing operation is packed into the cans with the slices.

• The pieces of pineapple trimmed from the fruit are diced and canned in the Crushing Department. Again, the juice generated during this operation is packed into the cans with the crushed pineapple.

• The core and surplus pineapple generated from the Cutting Department are pulverized into a liquid in the Juicing Department. There is an evaporation loss equal to 8 percent of the weight of the good out-put produced in this department that occurs as the juices are heated.

• The outside skin is chopped into animal feed in the Feed Department.

2. Juice, net realizable value:

$17,000

3. Allocation of joint cost,

slices: $30,160


Pass 3rd


Top Quality Fruit Company uses the net-realizable-value method to assign the costs of the joint process to its main products. The net realizable value of the by-product is subtracted from the joint cost before the allocation. A total of 270,000 kilograms were entered into the Cutting Department during June. The following schedule shows the costs incurred in each department, the proportion by weight transferred to the four final processing departments, and the selling price of each end product.

Processing Data and Costs for June

Department

Costs

Incurred

Proportion of

Product by Weight

Transferred to Departments

Selling Price

per Kilogram of

Final Product

Cutting ................................... $60,000 ...................................... — ........................................... —

Slicing ...................................... 4,700 ...................................... 35% ........................................... $0.60

Crushing ............................... 10,580 ...................................... 28 ........................................... 0.55

Juicing .................................... 3,250 ...................................... 27 ......................................... 0.30

Animal feed .............................. 700 ...................................... 10 .......................................... 0.10

Total ................................... $79,230 ...................................... 100%

Required: Compute each of the following amounts:

1. The number of kilograms of pineapple that result as output for pineapple slices, crushed pineapple, pineapple juice, and animal feed

2. The net realizable value at the split-off point of the three main products 3. The amount of the cost of the Cutting Department allocated to each of the three main products

(CMA, adapted)

Case 15–36 Comprehensive Case on Joint Cost Allocation (LO5, 6) Valdosta Chemical Company manufactures two industrial chemical products in a joint process. In May, 10,000 litres of input costing $60,000 were processed at a cost of $150,000. The joint process resulted in 8,000 kilograms of Resoline and 2,000 kilograms of Krypto. Resoline sells for $25 per kilogram, and Krypto sells for $50 per kilogram. Management generally processes each of these chemicals further in separable processes to produce more refined chemical products. Resoline is processed separately at a cost of $5 per kilogram. The resulting product, Resolite, sells for $35 per kilogram. Krypto is processed separately at a cost of $15 per kilogram. The resulting product, Kryptite, sells for $95 per kilogram.

Required:

1. Draw a diagram similar to Exhibit 15–9 to depict Valdosta Chemical Company’s joint production process.

2. Allocate the company’s joint production costs for May using a. The physical-units method b. The relative-sales-value method c. The net-realizable-value method

Note that further refining does not change the quantities.

3. Valdosta’s management is considering an opportunity to process Kryptite further into a new product called Omega. The incremental processing will cost $40 per kilogram. Packaging costs for Omega are projected to be $6 per kilogram, and the anticipated sales price is $130 per kilogram. Should Kryptite be processed further into Omega? Why or why not?

4. In answering requirement (3), did you use your joint cost allocation from requirement (2)? If so, how did you use it?

5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (2) and (3) above. Show how the solution will change if the following information changes: The joint cost is $245,000, and the sales price of Omega is $125 per kilogram.

1. Total joint cost: $210,000

2(b). Resoline, sales value at

split-off point: $200,000

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