Managerial Accounting, Chapter 14 by Crosson, Needles

Chapter 14

Allocation of Internal Service Costs and Joint

Product Costs

Copyright © Houghton Mifflin Company. All rights reserved. 14 | 2

Internal Service Providers

• Objective 1Discuss the allocation of internal service costs and explain its impact on decision making.


Internal Service Providers

Departments or centers that provide services internally to support the

activities of their business

• The costs of such internal services must be included in the full costs of a business’s products and services.– Ensures a company’s long-term profitability


Providing Support

Distribution Center

Fill orders for stores from inventory

Inspect goods arriving from

vendors

Process bulk goods through repackaging or

customizing

Service centers like the distribution center at Publix Supermarkets provide support to the other

divisions in a company.


Costs

Full Costs• Direct materials• Direct labor• All production

activities and nonproduction activities required to satisfy the customer

Traceable Costs• Direct costs that can be

traced to the product or service

Assigned Costs• Other essential but not

necessarily traceable indirect costs that must be assigned


Common Service Costs

• Mutually beneficial indirect costs• Support service activities that are billed to

customers, patients, or clients• Must be assigned to users of the activities

to determine the full cost of the services they offer


Cost Allocation

• The process of assigning common costs to specific cost objects using an allocation base

• Does not change an organization’s total costs

• Merely shifts costs from the service providers to the responsibility centers that benefit from those services

• Enables a business to calculate the full cost of its products or services and set prices accordingly

Internal service providers do not charge any of their services to users outside the organization.

Revenue centers bill their services or products to external users.


Planning

• Management identifies the activities within internal service centers or departments.

• Cost allocation methods and allocation bases are determined.

Publix Distribution

Center

• Receiving• Shipping • Repackaging • Truck Maintenance • Fuel • Utilities • Logistics Administration

These activity centers generate costs, but no revenues.


Performing

• Managers control the costs of their respective areas of responsibility.

• The costs of activity centers are assigned using the agreed-upon allocation bases and method.– Revenue centers (stores) add the assigned costs to

their overhead costs to compute a departmental overhead rate.

– The overhead rate is applied to products and services to determine the total cost and unit cost of a product or service.


Evaluating

Managers evaluate:• Customer profitability• Product or service performance• Appropriateness of the cost-allocation bases

and method used


Communicating

• Cost allocation reports prepared for managers• Used in monitoring costs, allocation bases,

and the cost-allocation method• Help managers make more informed decisions

about their areas of responsibility

Managers become informed consumers of internal services and are better able to evaluate

the effectiveness of those services by improving their understanding of full cost.


Stop & Review

Q. What are common costs?

A. Common costs are mutually beneficial indirect costs and must be assigned to the users of common activities.


Responsibility Centers and the Allocation of Service Costs

• Objective 2Describe the two kinds of responsibility centers used in allocating service costs.


Responsibility Center

An organizational unit whose manager has been assigned the responsibility of managing

a portion of the organization’s resources

• Costs are incurred and controlled at the center level.• All center costs (direct materials, direct labor,

and overhead) can be logically traced to the center’s activities.


Responsibility Centers andthe Allocation of Service Costs

• Responsibility centers are divided into two categories for the allocation of service costs:– Revenue centers– Service centers


Revenue Centers

Responsibility centers that are directly responsible for producing products or

services sold to external buyers

Also known as producing centers

or operating centers

• Incur their own traceable costs• Are assigned the costs of other

responsibility centers from which they benefit


Service Centers

Responsibility centers that provide benefits to other responsibility centers

Also known as support centers (indirectly support the activities of the revenue centers and

other service centers)


Service Centers (cont’d)

The traceable costs of a service center are:• Collected and controlled by that center• Then assigned to other centers using an allocation

base, or cost driver

Cost driver• An activity that causes another center’s use of a service center


Examples of Service Centersand Related Cost Drivers


Responsibilities of Managers

• Determine which responsibility centers are service centers and which are revenue centers

• Select a method of cost allocation• Decide the order in which service costs will

be assigned• Choose cost drivers


Methods of AssigningDirect Service Costs

Allocation may also be based on:• Full recognition of service users• Ability to pay• Number of users

• Direct method

• Step method


Stop & Review

Q. What is the difference between a revenue center and a service center?

A. Revenue center– Directly responsible for producing products or

services for external buyers

Service center– A responsibility center that supports the activities

of the revenue centers and other service centers


Direct Method ofService Cost Allocation

• Objective 3Use the direct method to assign service costs.


Direct Method of Service Cost Allocation

Is an activity-based cost-allocation method that assigns the costs of service

centers only to revenue centers


Direct Method ofService Cost Allocation (cont’d)

• Advantages– Easy and straightforward

• Disadvantages– May not reflect the revenue centers’ actual use of

services• Because it assigns service costs to revenue centers only

Ignores the fact that service centers provide service and support to other service centers as well as to

revenue centers


Steps to Assign Service Center Costs

1. Calculate allocation fractions.2. Determine the dollar amount to assign to

each revenue center.3. Total the costs for each revenue center.


Direct Method of Service Cost Allocation Illustrated

City Hospital has three service centers—Housekeeping, Human Resources, and Marketing—and three revenue centers—Emergency Room, Radiology, and Laboratory. Total costs during the accounting period were $100 for Housekeeping, $120 for Human Resources, and $150 for Marketing.

• Housekeeping– Percentage of square feet occupied by the center

• Human Resources– Number of employees in the center

• Marketing– Sales dollars generated by the center

Cost Drivers


Direct Method of Service Cost Allocation Illustrated (cont’d)

The hospital’s management accountant has measured each cost driver for each center:

City Hospital has three service centers—Housekeeping, Human Resources, and Marketing—and three revenue centers—Emergency Room, Radiology, and Laboratory. Total costs during the accounting period were $100 for Housekeeping, $120 for Human Resources, and $150 for Marketing.


Step 1:Calculate Allocation Fractions

• Under the direct method:

AmountsDriver Cost Centers' Revenue All of Sum

AmountDriver Cost Specific sCenter' Revenue Fraction Allocation

Remember that under the direct method, only the cost driver amounts for revenue centers are used in

determining allocation fractions.


Step 1:Calculate Allocation Fractions (cont’d)

Housekeeping15/70 30) 25 15/(15 :RoomEmergency 25/70 30) 25 25/(15 :Radiology 30/70 30) 25 30/(15 :Laboratory

Human Resources90/540 240) 210 90/(90 :RoomEmergency

210/540 240) 210 210/(90 :Radiology 240/540 240) 210 240/(90 :Laboratory

Marketing600/2,300 900) 800 600/(600 :RoomEmergency 800/2,300 900) 800 800/(600 :Radiology 900/2,300 900) 800 900/(600 :Laboratory


Step 2: Determine the Dollar Amount toAssign to Each Revenue Center

• Multiply each center’s total costs by the corresponding revenue center allocation fraction calculated in Step 1.


Step 2: Determine the Dollar Amount to Assign to Each Revenue Center (cont’d)

Housekeeping, $100$21 ) /70)($100(15 :RoomEmergency $36 00)(25/70)($1 :Radiology $43 00)(30/70)($1 :Laboratory

Human Resources, $120$20 120)(90/540)($ :RoomEmergency

$47 $120)(210/540)( :Radiology $53 $120)(240/540)( :Laboratory

Marketing, $150$39 )($150)(600/2,300 :RoomEmergency $52 )($150)(800/2,300 :Radiology $59 )($150)(900/2,300 :Laboratory


Step 3: Total the Costs forEach Revenue Center

• Add the assigned costs to the other costs incurred in the revenue centers.

Costs incurred in the revenue centersEmergency Room: $400

Radiology: $500Laboratory: $600

$480 $39 $20 $21 $400 :RoomEmergency $635 $52 $47 $36 500$ :Radiology $755 $59 $53 $43 $600 :Laboratory

Total costs for each revenue center


Step 3: Total the Costs forEach Revenue Center (cont’d)

• No dollars are lost or gained in the allocation process.

• Total revenue center costs after allocation equal total center costs before allocation.


Stop & Review

Q. Why is it that total revenue center costs after allocation equal total center costs?

A. Before allocation, total center costs include costs of service centers and costs of revenue centers. After allocation, service center costs have been transferred to the revenue centers so that all costs are recorded in the revenue centers and no costs remain in the service centers.


Step Method ofService Cost Allocation

• Objective 4Use the step method to assign service costs.


Step Method ofService Cost Allocation

Assigns service center costs to both service and revenue centers based on

descending order of use

• Costs of the service center used most by other centers are assigned first.

• Costs of the service center used least are assigned last.• Once the costs of a service center have been assigned,

it is closed; it cannot receive any assigned costs from any other service center.


Step Method ofService Cost Allocation (cont’d)

• Also known as the step-down method– Resembles stair steps

• Recognizes the fact that service centers provide service and support to the service centers, as well as to revenue centers

Although the step method attempts to recognize interdepartmental use, other methods must be used to recognize the full reciprocal usage of services.


Assigning Service CenterCosts to Revenue Centers

1. Calculate the allocation fraction.2. Determine the dollar amount to assign to each

open service center and each revenue center.3. Total the costs for each revenue center.


Step 1:Calculate the Allocation Fraction

Under the step method:

AmountsDriver Centers'

Revenue and ServiceOpen All of Sum

AmountDriver Cost Specific sCenter' Fraction Allocation sCenter'

Hospital managers have ranked the service centers in the following order of most to least services provided and used: 1. Housekeeping2. Human Resources3. Marketing


Step 1:Calculate the Allocation Fraction (cont’d)

Calculate the allocation fractions for Housekeeping:

15/95 30) 25 15 15 15/(10 :RoomEmergency 25/95 30) 25 15 15 25/(10 :Radiology 30/95 30) 25 15 15 30/(10 :Laboratory

10/95 30) 25 15 15 10/(10 :ResourcesHuman 15/95 30) 25 15 15 15/(10 :Marketing



Calculate the allocation fractions for Human Resources:

30/570 240) 210 90 30/(30 :Marketing

90/570 240) 210 90 90/(30 :RoomEmergency

210/570 240) 210 90 210/(30 :Radiology

240/570 240) 210 90 240/(30 :Laboratory



Calculate the allocation fractions for Marketing:

600/2,300 900) 800 600/(600 :RoomEmergency 800/2,300 900) 800 800/(600 :Radiology 900/2,300 900) 800 900/(600 :Laboratory


Step 2: Determine the Dollar Amount to Assign to Each Open Service Center and Each Revenue Center

• Multiply each service center’s total costs by the corresponding service or revenue center allocation fraction calculated in Step 1.

• Important:– Include both that service center’s own costs and

any costs that have been assigned to it.– Recall that once a service center’s costs have

been assigned, that center cannot receive any more assigned costs.


Step 2: Determine the Dollar Amount to Assign to Each Open Service Center and Each Revenue Center (cont’d)

Assign the costs of Housekeeping, $100

down) (rounded $10 00)(10/95)($1 :ResourcesHuman

$16 00)(15/95)($1 :RoomEmergency

$26 00)(25/95)($1 :Radiology

$32 00)(30/95)($1 :Laboratory

$16 00)(15/95)($1 :Marketing


Assign the costs of Human Resources, $130

down) (rounded $20 130)(90/570)($ :RoomEmergency

$48 $130)(210/570)( :Radiology

$55 $130)(240/570)( :Laboratory

$7 130)(30/570)($ :Marketing

The costs of Human Resources include center costs of $120 and assigned costs of $10.




The costs of Marketing include center costs of $150 and assigned costs of $16 from Housekeeping and $7 from Human Resources.

Assign the costs of Marketing, $173

$45 )($173)(600/2,300 :RoomEmergency

$60 )($173)(800/2,300 :Radiology

$68 )($173)(900/2,300 :Laboratory


Step 3: Total the Costs forEach Revenue Center

• Add the assigned service costs to the other costs incurred in the revenue centers.

• Note:– No dollars are lost or gained in the allocation

process.– Total revenue center costs after allocation equal

total center costs before allocation.

Assigned amounts may be rounded up or down to ensure that the two total figures are equal.



$481 $45 $20 $16 400$ :RoomEmergency

Calculate the total for each revenue center:

$634 $60 $48 $26 500$ :Radiology

$755 $68 $55 $32 600$ :Laboratory



Total Revenue Center Costs After Allocation Emergency Room Radiology Laboratory

Direct Method $480 $635 $755 Step Method $481 $634 $755

The total amount of service costs assigned to a given

revenue center varied little in this example.

In actual practice, the total costs assigned to a revenue

center may vary significantly from method to method.


Stop & Review

Q. What is a benefit of the step method of cost allocation over the direct method? A drawback?

A. Benefit• The step method recognizes interdepartmental use,

whereas the direct method does not.

Drawback• The step method is not as simple as the direct method.


Other Methods ofService Cost Allocation

• Objective 5Describe the two-step method, the simultaneous equation method, the ability to pay method, and the physical measures method of assigning service costs.


Other Methods ofService Cost Allocation

• Some businesses do not assign service costs at all, but charge departments for the goods and services they use.

• Full recognition of service users method• Ability to pay method• Physical measures method


Full Recognition ofService Users Method

Can use either of two methods of service allocation under this approach:• Two-step method • Simultaneous equation method


Allocation: Two-Step Method

• The step method is performed twice:– First, to apportion all service costs among

service centers, with no service center closed to accepting costs

– Second, to assign all service center costs to the revenue centers


Allocation:Simultaneous Equation Method

• A cost formula is set up for each service and revenue center.– Expresses the center’s full use of all other

center services

• All the formulas are simultaneously solved to determine the full cost of each revenue department.

• The simultaneous equation method is also called the reciprocal method.


Ability to Pay Method

• Revenue centers with the greatest ability to pay absorb most of the service center costs.

• The ability to pay method uses a readily available cost driver, such as sales dollars, to assign service center costs.


Physical Measures Method

• Easiest method of service cost allocation• Based on the number of centers instead of on

an activity of the centers– A service center’s costs are divided by the number

of centers that use its services and assigned in equal portions.

May tempt managers to use service more than necessary because all centers pay the same amount

regardless of use


Stop & Apply

Q. Using the physical measures method of service cost allocation, what amount of a service center’s $1,500 of costs will be assigned to each of three centers that use its services?

A. The total costs are divided by the number of centers that use the services and assigned evenly. Each center will be assigned $500 of costs ($1,500 ÷ 3).


Application of Overhead Rates

• Objective 6Explain how service cost allocation relates to overhead rates.


Application of Overhead Rates

• Each service center then calculates either:– A single departmental

overhead rate– Several activity-based

overhead rates

• The resulting rate or rates are then used to apply indirect costs to products and services.

Once service center costs have been

assigned to revenue centers, they are

combined with each revenue center’s

overhead (traceable indirect costs).


Cost Allocation Process


Departmental Overhead Rates

DriverCost

Costs Service Assigned OverheadCenter Revenue Rate Overhead

A single rate that includes all overhead costs of the department

Used to determine the full cost of a product or service


Activity-Based Costing Rates

• Using several activity-based rates instead of a single departmental overhead rate– Improves a revenue center manager’s ability

to manage and control different types of overhead costs


Activity-Based Costing Rates (cont’d)

• Under activity-based costing (ABC):– A revenue center has multiple overhead rates

based on the activities of that center.– Those rates are used to assign the costs of their

respective activities to a product or service to determine its full cost.


True Cost of a Product or Service

• To determine how much a product or service truly costs, it must include:– Direct materials– Direct labor– Overhead– Costs of services provided by other departments

• Even if managers must use judgment in assigning service costs


Limitations and Benefits of Cost-Allocation Policies

Limitations • Arbitrary cost-

allocation methods can lead to– Poor product pricing– Rejection of

potentially lucrative business opportunities

Benefits• Improved

information for decision making

• Full knowledge of all the costs of products and services


Stop & Review

Q. How is a departmental overhead rate computed?

DriverCost

Costs Service Assigned OverheadCenter Revenue Rate Overhead

A. It is computed by adding the service costs assigned to a revenue center to its overhead costs, then dividing by the appropriate activity-based cost driver.


Stop & Review (cont’d)

Q. What elements are included in the true cost of a product or a service?

A. Direct materials, direct labor, overhead, and costs of services provided by other departments


Allocation of Joint Product Costs

• Objective 7Apply allocation methods to the costs associated with joint products.


Allocation of Joint Product Costs

Joint products– Two or more major products that are produced from a

common source

By-products– Products with minor sales value that are produced

simultaneously with joint products from a common source

Products can be made by combining materials or by splitting materials apart.


Joint Costs

• Processing costs and materials costs that joint products share

• Incurred prior to the separation of joint products


Separable Costs and Split-off Point

Separable CostsCosts incurred after separation of joint products

Split-Off Point • Point at which joint products first become separate,

identifiable products• Costs incurred up to the split-off point must be

allocated to the joint products by one of three allocation methods:1. Physical measures method2. Relative sales value method3. Net realizable method


Allocation Methods for Joint Costs

A cotton mill processes cotton bolls into cotton fiber, cottonseed, and animal feed. A ton of cotton bolls costs $1,000. Joint processing costs of $200 result in 500 pounds of fiber, 750 pounds of seed, and 750 pounds of animal feed. At split-off, the cotton fiber can be sold for $600, the cottonseed for $400, and the animal feed for $200. Cottonseed can be processed further at a cost of $100 into $600 gallons of cottonseed oil that sells for $1 per gallon.

Allocate joint cost to products using the physical units method, the relative sales value method, and the

net realizable method.


Allocation of Joint Costs


Physical Units Method

• Allocates joint costs to units based on their relative physical quantities, such as weight, volume, or units

Advantages: • Objectivity • Ease of Use

Disadvantage:• Ignores the

revenue value of products


Physical Units Method (cont’d)

• The joint products’ total weight of 2,000 pounds is used as the denominator to allocate the $1,200 joint cost.


Relative Sales Value Method

Allocates joint costs to products based on their relative market value at the split-off point

Advantage: • Fairness in

allocating costs to the products most likely to be able to absorb them

Disadvantage: • Inability to readily determine

market value at split-off due to fluctuating market prices and inability to sell product at split-off without further processing


Relative Sales Value Method (cont’d)

• The denominator for allocating the $1,200 joint cost is the total relative sales value at split-off point, or $1,000.


Net Realizable Value Method

• Allocates joint costs to products based on their eventual sales value less any separable costs necessary to make them salable.

• Advantage:– Profit comparability among products for

allocation and decision-making purposes


Net Realizable Value Method (cont’d)

• Relative sales value and net realizable value are the same for fiber and feed since there are no separable costs.

• If cottonseed is processed further into cottonseed oil, its net realizable value is $500 ($600 – separable costs of $100).

• The denominator used for joint cost allocation is $1,300.

Net Realizable Value Method: Joint Products Net Realizable Value Proportion Joint Cost Cotton fiber $ 600 600/1,300 $ 554 Cottonseed 500 500/1,300 461 Animal feed 200 200/1,300 185 Total $1,300 $1,200

Amounts in the Joint Cost column have been rounded.


Sell or Process-FurtherDecisions and Joint Costs

• Remember, in this kind of decision, joint costs are ignored and only separable costs are used (costs that change between alternatives).


By-Products

• The difference between by-products and joint products is their relative market value.– Joint products are primary products produced.– By-products are simultaneously produced with

joint products, but have minimal market value.

Sometimes by-products become joint products due to changing market preferences, as was the case with

sawdust eventually being compressed into particle board.


Stop & Review

Q. What is an advantage of the net realizable value method of allocation for joint costs?

A. An advantage of this method is profit comparability among products for allocation and decision-making purposes.


Chapter Review

1. Discuss the allocation of internal service costs and explain its impact on decision making.

2. Describe the two kinds of responsibility centers used in allocating service costs.

3. Use the direct method to assign service costs.4. Use the step method to assign service costs.


Chapter Review (cont’d)

5. Describe the two-step method, the simultaneous equation method, the ability to pay method, and the physical measures method of assigning service costs.

6. Explain how service cost allocation relates to overhead rates.

7. Apply allocation methods to the costs associated with joint products.

Managerial Accounting, Chapter 14 by Crosson, Needles

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