EMBA 5412 Cost and Revenue Allocation

Cost and Revenue Allocations

EMBA 5412 Fall 2010

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Introduction

We will emphasize the allocation of costs to

divisions, plants, departments, and contracts;

also address the common cost allocation the joint cost allocations; and the revenue allocations

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Why allocate Cost?

We allocate indirect costs that can not be easily traced to products, services, etc.

Why do managers allocate indirect costs to these cost objects?

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Purposes of Cost Allocation

1 To provide information for economic decisions

2 To motivate managers and other employees

3 To justify costs or compute reimbursement

4 To measure income and assets for reporting to external parties

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Criteria

Cause-and-effect: identify the variable or variables that cause resources to be consumed

Allocation based on this relation would be the most acceptable by the departments/managers

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Criteria

Benefits-received: managers identify the beneficiaries of the outputs of the cost object

The costs of the cost object are allocated among the beneficiaries in proportion to the benefits each receives

Have to convince the managers of departments

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Criteria

Fairness or equity: This criterion is often cited on government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers.

Cost allocation is viewed as a “reasonable” or “fair” means of establishing a selling price in the minds of the contracting parties.

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Criteria

Ability to bear: This criterion advocates allocating costs in proportion to the cost object’s ability to bear them.

An example is the allocation of corporate executive salaries on the basis of division operating income.

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Cost-Benefit Approach Companies place great importance on the

cost-benefit approach when designing and implementing their cost-allocation system.

The costs of designing and implementing a system are highly visible.

The benefits from using a well-designed system are difficult to measure and are frequently less visible.

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Allocating Costs of a Supporting Department to Operating Departments

Supporting (Service) Department – provides the services that assist other internal departments in the company

Operating (Production) Department – directly adds value to a product or service

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Methods to Allocate Support Department Costs

Single-Rate Method – allocates costs in each cost pool (service department) to cost objects (production departments) using the same rate per unit of a single allocation base No distinction is made between fixed and

variable costs in this method

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Methods to Allocate Support Department Costs

Dual-Rate Method – segregates costs within each cost pool into two segments: a variable-cost pool and a fixed-cost pool.

Each pool uses a different cost-allocation base

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Allocation Method Tradeoffs

Single-rate method is simple to implement, but treats fixed costs in a manner similar to variable costs

Dual-rate method treats fixed and variable costs more realistically, but is more complex to implement

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Allocation Bases Under either method, allocation of support

costs can be based on one of the three following scenarios:

1. Budgeted overhead rate and budgeted hours2. Budgeted overhead rate and actual hours3. Actual overhead rate and actual hours

Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period

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Methods of Allocating Support Costs to Production Departments

1. Direct2. Step-Down3. Reciprocal

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Direct Method

Allocates support costs only to Operating Departments

No interaction between Support Departments prior to allocation

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Direct Method

Manufacturing

Information Systems

Accounting

Packaging

Support Departments Production Departments

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Service Allocation: Direct Method Procedure: Ignore each service department’s use of other service

departments. Allocate service department costs only to operating

departments.

Advantages: Simple to administer and explain.

Disadvantages: Allocations are not accurate estimates of opportunity costs

when service departments use other service departments. Incentives exist for service departments to make excessive

use of other service departments.

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Step-Down Method

Allocates support costs to other support departments and to operating departments that partially recognizes the mutual services provided among all support departments

One-way interaction between Support Departments prior to allocation

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Step-Down Method

Manufacturing

Information Systems

Accounting

Packaging


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Service Allocation: Step-down Method

Procedure: Start with one service department and allocate all of its costs to the

remaining service and operating departments. Continue one-by-one through each service department allocating all direct costs of that department and costs allocated to it. A good way of choosing the order of allocation is by (1) most reliable

“cause and effect” cost driver, (2) number of other departments serviced, and (3) finally, as the default, total budget of department.

Advantages: Considers some of the interdependence of service departments

Disadvantages: Resulting allocations are inaccurate estimates of opportunity costs. Allocation less than opportunity cost for first department Allocation more than opportunity cost for last department

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Reciprocal Method

Allocates support department costs to operating departments by fully recognizing the mutual services provided among all support departments

Full two-way interaction between Support Departments prior to allocation

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Reciprocal Method

Manufacturing

Information Systems

Accounting

Packaging


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Service Allocation: Reciprocal Method Procedure: Write equations defining variable cost relationships among

divisions. Solve system of simultaneous equations with linear algebra. Allocate fixed costs based on each operating division’s planned

use of the service department’s capacity.

Advantages: Most accurate method (best approximates opportunity costs)

Disadvantages: Slightly harder to set up and compute solution Difficult to explain results to unsophisticated managers Prevents managers from “managing” cost allocations for

financial reporting and/or taxes.

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Choosing Between Methods

Reciprocal is the most precise Direct and Step-Down are simple to

compute and understand Direct Method is widely used

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Example

DATA Support Depts Operating Depts

Plant Maintenance

Information Systems Machining Assembly Total

Budgeted Manufacturing Overhead Cost before allocations (TL) 600.000 116.000 400.000 200.000 1.316.000Support work provided:By Plant Maintenance Budgeted Labor hours 1600 2400 4000 8.000 Percentage 20% 30% 50% 100%By Information Systems Budgeted Computer hours 200 1600 200 2.000 Percentage 10% 80% 10% 100%

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Direct MethodBudgeted Cost

Budgeted Cost Operating Depts

Support Departments Machining Assembly TotalBudgeted Manufacturing Overhead Cost before allocations 600.000 116.000 400.000 200.000 1.316.000Plant Maintenance

Labor Hours 2400 / (2400+4000)

4000/ (2400+4000)

Percentage 0,375 0,625 Allocated Plant Main Cost (600.000) 225.000 375.000 600.000

Information System

Computer Hours 1600/ (1600+200)

200/ (1600+200)

Percentage 0,889 0,111 Allocated Info System Cost (116.000) 103.111 12.889 116.000

Total Budgeted Overhead 728.111 587.889 1.316.000

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Step-down method

Two service depts; We can start with either one but would

yield different results Usually start with the service dept that

provides a higher percentage of service to other service departments first

Rank the service departments in the order that they provide service to other service departments

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step-down with plant maintenance first

Budgeted Cost


Support Departments Machining Assembly TotalBudgeted Manufacturing Overhead Cost before allocations 600.000 116.000 400.000 200.000 1.316.000Plant Maintenance Labor Hours 1600 2400 4000 8.000 Percentage 20% 30% 50% 100% Allocated Plant Main Cost (600.000) 120.000 180.000 300.000 600.000

Information System

Computer Hours 1600/ (1600+200)

200/ (1600+200)

Percentage 0,889 0,111 Allocated Info Sys Cost (236.000) 209.778 26.222 236.000


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step-down with information system first

Budgeted Cost


Support Departments INFO SYS PLANT Machining Assembly TotalBudgeted Manufacturing Overhead Cost before allocations 116.000 600.000 400.000 200.000 1.316.000Information System Computer Hours 200 1600 200 2.000 Percentage 10% 80% 10% 100% Allocated Info Sys Cost (116.000) 11.600 92.800 11.600 116.000Plant Maintenance

Labor Hours 2400 / (2400+4000)

4000/ (2400+4000)

Percentage 38% 63% 100% Allocated Plant Main Cost 611.600 229.350 382.250 611.600


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Comparison of Methods

Direct

Step down Plant Main

first

Step down Info Sys

firstMachining 728.111 789.778 722.150Assembly 587.889 526.222 593.850

Total 1.316.000 1.316.000 1.316.000

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Reciprocal computation

[A]= Plant 0 0,1Info 0,2 0

[I] = 1 00 1

[I- A]= 1,00 -0,10-0,20 1,00

det [I-A] = 0,98

1/ det[I-A] = [I-A] inverse 1,02 0,1020,204 1,0204

cost [C] = Plant 600.000Info 116.000

multiply [I- A] inverse x [C] = 624.082240.816

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Reciprocal allocation

Budgeted Cost


Support Departments Plant Info Sys Machining Assembly TotalBudgeted Manufacturing Overhead Cost before allocations 600.000 116.000 400.000 200.000 1.316.000Allocation of Plant Maintenance Percentage 20% 30% 50% 100% Amount (624.082) 124.816 187.224 312.041Allocation of Information System Percentage 10% 80% 10% 100% Amount 24.082 (240.816) 192.653 24.082

779.878 536.122 1.316.000Total budgeted overhead for operating departments

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Comparison

Direct

Step down Plant Main

first

Step down Info Sys

first ReciprocalMachining 728.111 789.778 722.150 779.878Assembly 587.889 526.222 593.850 536.122

Total 1.316.000 1.316.000 1.316.000 1.316.000

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Service Department Cost Allocation assuming separate fixed and variable costs

Example Dual rates are used Distributed in class

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Allocating Common Costs

Common Cost – the cost of operating a facility, activity, or like cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user

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Methods of Allocating Common Costs

Stand-Alone Cost-Allocation Method – uses information pertaining to each user of a cost object as a separate entity to determine the cost-allocation weights

Individual costs are added together and allocation percentages are calculated from the whole, and applied to the common cost

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Example – Common costs The manager of your plants in Russia wanted to

consult you and wanted you to visit their sites.Below are the possible fares for these trips individually or combined. You will charge the cost of your plane ticket to these two sites.

Dubna and St.Petersburg Ankara-Dubna-Ankara costs TL 800 Ankara-St.Peterburg-Ankara costs TL 1300 Ankara-Dubna-St.Peterburg-Ankara costs TL 1900 How would you allocate the cost between these two

sites?

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Example common costs – stand alone

Determine weights:

Dubna =

St.Peterburg =

Then costs are Dubna 38.1% *1900= 723.90St.Peterburg 69.1% *1900 =1176.10

%1.381300800

800

%9.611300800

1300

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Methods of Allocating Common Costs Incremental Cost-Allocation Method ranks the

individual users of a cost object in the order of users most responsible for a common cost and then uses this ranking to allocate the cost among the users The first ranked user is the Primary User and is

allocated costs up to the costs of the primary user as a stand-alone user (typically gets the highest allocation of the common costs)

The second ranked user is the First Incremental User and is allocated the additional cost that arises from two users rather than one

Subsequent users handled in the same manner as the second ranked user

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Example common cost

Assuming Dubna plant is the first user Dubna gets 800 TL; St.Peterburg gets

1900 – 800 = 1100 TL Assuming St.Peterburg is the first

St.Peterburg gets 1300 TL; Dubna gets 1900 – 1300 = 600 TL

Probably have to agree with the management.

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Cost Allocations and Government Contracting

two main ways:1. The contractor is paid a set price without

analysis of actual contract cost data2. The contractor is paid after an analysis

of actual contract cost data. In some cases, the contract will state that the reimbursement amount is based on actual allowable costs plus a fixed fee (cost-plus contract)

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Death Spiral Death spiral occurs when large fixed costs of a

common resource are allocated to users who could decline to use that resource. As the allocated costs increase, some users choose to decrease use. Then the fixed costs are allocated to the remaining users, more of whom use less. This process repeats until no users are willing to pay the fixed costs.

Possible solutions to death spiral: When excess capacity exists, charge users only for

variable costs. Reduce the total amount of fixed costs allocated.

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Death Spiral Example: Cost-based Contracts

Defense contractors working on advanced technology incur large fixed cost over-runs that are allocated to each aircraft manufactured.

Government reduces number of aircraft purchased and that causes average cost to increase on remaining orders.

Government responds by ordering even fewer aircraft.

Eventually, the entire project is abandoned before all fixed costs are recovered.

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Joint cost allocation

Joint cost is incurred to produce two or more outputs from the same input.

Joint costs occur only in disassembly processes, such as refining and food processing.

Common costs occur in either disassembly or assembly processes, such as building cars

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Joint Costs: Process Further? Split-off point: the point in the disassembly

processing at which all joint costs have been incurred

Decision: Should each joint product be processed further or sold as is at the split-off point?

Solution concept: The joint costs are sunk costs at the split-off point. Do the incremental benefits of further processing exceed the incremental costs?

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Joint Costs: Net Realizable Value Net realizable value (NRV) is the difference

between selling price and costs that would be incurred after the split-off point. Compute NRV of each product after the split-off

point. Decide to produce products with positive NRV, but not with negative NRV.

For control and divisional reporting, allocate joint costs to products in the ratio of the NRV of each product.

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Joint costs- example

Raw MILK

Process further

Yogurt

White Cheese

Split off point

Sell as MILK

PasteurizeMILK

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Joint costs example In June 2008, Bizim Sut processes 220,000 lt of raw milk.

During processing until the split off point 10,000 lt are lost due to evaporation, spillage,etc.

After the split off point, the may be processed further to yogurt or cheese that share a second common processing which costs 200.000 TL .

Price of milk: 1.50 TL per lt Price of Yogurt 3.50 TL per kg; further processing cost 0.60

TL per kg Price of cheese 7 TL per kg further processing cost 2 TL per

kg Joint cost of processing raw milk 100.000 TL The company decides to sell half of pasteurized milk as is;

and process the rest yielding 75,000 kg yogurt and 25,000 cheese losing 5,000 lt more during the process.

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Joint cost example

JOINT COST 1 Milk Yogurt and CheeseSales value at split off amount (lt,kg) 105.000 105.000 210.000 sales price (lt, kg) 1,50 4,00Total Sales value 157.500 420.000 Weights of sales value 50,0% 50,0%JOINT COST 1 Allocation (100.000) 50.000 50.000

joint cost 1 per lt or kg 0,48 0,48

Based on physical units

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Joint costs example

JOINT COST 2 Yogurt CheeseSales value at split off amount (lt,kg) 75.000 25.000 sales price (lt, kg) 3,50 7,00Total Sales value 262.500 175.000 437.500 Weights of sales value 60,00% 40,00%JOINT COST 2 Allocation (200.000) 120.000 80.000

joint cost 1 per lt or kg 1,60 3,20

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Joint costs example

Using NRVJOINT COST 2 Yogurt CheeseSales value at split off amount (lt,kg) 75.000 25.000 sales price (lt, kg) 3,50 7,00Total Sales value 262.500 175.000 437.500 Separable Costs per kg 0,60 2,00Less Separable Costs 45.000 50.000Net Realizable Value at Split-off 217.500 125.000 342.500

Weights of sales value 63,50% 36,50%JOINT COST 2 Allocation (200.000) 127.007 72.993

joint cost 1 per kg 1,69 2,92

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Joint costs comparison

Yogurt CheeseTOTAL COST per kg sales value 2,68 5,68

NRV 2,77 5,40

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Revenue Allocation and Bundled Products Revenue Allocation occurs when revenues

are related to a particular revenue object but cannot be traced to it in an economically feasible manner

Revenue Object – anything for which a separate measurement of revenue is desired

Bundled Product – a package of two or more products or services that are sold for single price, but individual components of the bundle also may be sold as separate items at their own “stand-alone” prices

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Methods to Allocate Revenue to Bundled Products

Stand-Alone (separate) Revenue Allocation Method uses product-specific information on the products in the bundle as weights for allocating the bundled revenues to the individual products. Three types of weights may be used:

1. Selling Prices2. Unit Costs3. Physical Units

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Example Cybersoft produces and sells three software

programs: Writeperfect; Computeperfect; and Graphperfect.

Cybersoft sells these products individually as well as bundled products.

Selling PriceManufacturing Cost

per UnitIndividually TL TL Writeperfect 125 18Computeperfect 150 20Graphperfect 225 25Bundled:Write and Compute 220Write and Graph 280Compute and Graph 305Write, Compute and Graph 380

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ExampleIndividual Revenue Allocation

Use Selling Prices

total individual

pricesbundle price write compute graph

write and compute 275 220 0,45 0,55prices of individual products 100,00 120,00

write and graph 350 280 0,36 0,64prices of individual products 100,00 180,00

compute and graph 375 305 0,40 0,60122,00 183,00

write, compute and graph 500 380 0,25 0,30 0,4595,00 114,00 171,00

weights and prices

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Methods to Allocate Revenue to Bundled Products Incremental Revenue-Allocation Method ranks individual

products in a bundle according to criteria determined by management and then uses this ranking to allocate bundled revenues to individual products The first-ranked product is the primary product The second-ranked product is the first incremental product The third-ranked product is the second incremental product,

etc. If the bundled price is more than the individual price of the

primary product, the primary product is allocated its regular price; and then the secondary product gets its regular price; and so forth

If the bundled price is less than or equal to the individual price of the primary product, the primary product is allocated 100% of revenue; and the others in the same bundle receive no allocation

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ExampleIncremental Revenue Allocation Method

let's assume the following rank: Write Graph Compute

Product BundleBundle Price

Revenue Allocated

Cumulative Revenue Allocated

Writeperfect Write and Compute 220Write 125 125 Compute 95 220

Write and Graph 280Write 125 125Graph 155 280

Computeperfect Compute and Graph 305Graphperfect Compute 150 150

Graph 155 305

write,compute and graph 380Write 125 125Compute 150 275Graph 105 380

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Example-Shapley allocation

PrimaryFirst

incrementalSecond

Incremental Write Compute GraphWrite Compute Graph 125 95 160

(220-125) (380-220)Write Graph Compute 125 100 155

(380-280) (280-125)Compute Write Graph 70 150 160

(220-150) (380-220)Compute Graph Write 75 150 155

(380-305) (305-150)Graph Write Compute 55 100 225

(280-225) (380-280)Graph Compute Write 75 80 225

(380-305) (305-225)

Order Revenues Allocated to each product

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Example-Shapley value

PrimaryFirst

incrementalSecond

Incremental Write Compute GraphWrite Compute Graph 125 95 160Write Graph Compute 125 100 155Compute Write Graph 70 150 160Compute Graph Write 75 150 155Graph Write Compute 55 100 225Graph Compute Write 75 80 225

87,5 112,5 180

Order Revenues Allocated to each product

average price=Shapley value

Assume equal weights on all products.

EMBA 5412 Cost and Revenue Allocation

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