Accy121 finalexaminstrmanualchs9 11_13_16_appendix

Chapter 9
Activity-Based Costing
Learning Objectives
1. Understand the potential effects of using externally reported product costs for decision
making.

2. Explain how a two-stage product costing system works.

3. Compare and contrast plantwide and department allocation methods.

4. Explain how activity-based costing and a two-stage product system are related.

5. Compute product costs using activity-based costing.

6. Compare activity-based product costing to traditional department product costing
methods.

7. Demonstrate the flow of costs through accounts using activity-based costing.

8. Apply activity-based costing to marketing and administrative services.

Instructor’s Manual Chapter 9 177

Chapter Outline
I. REPORTED PRODUCT COSTS AND DECISION MAKING
A. Dropping a product
B. The death spiral
II. TWO-STAGE COST ALLOCATION
A. Two-stage cost allocation and the choice of cost drivers
B. Plantwide versus department-specific rates
C. Choice of cost allocation methods: A cost-benefit decision
III. ACTIVITY-BASED COSTING
♦ Developing activity-based costs
• Identifying activities that use resources
• Choosing cost drivers
• Computing a cost rate per cost driver
• Assigning costs to products
IV. COST HIERARCHIES
V. ACTIVITY-BASED COSTING ILLUSTRATED
A. Step 1: Identify the activities
B. Step 2: Identify the cost drivers
C. Step 3: Compute the cost driver rates
D. Step 4: Assign costs using activity-based costing
E. Unit costs compared
VI. COST FLOW THROUGH ACCOUNTS
VII. CHOICE OF ACTIVITY BASES IN MODERN PRODUCTION SETTINGS
VIII. ACTIVITY-BASED COSTING IN ADMINISTRATION
IX. WHO USES ABC?
X. SUMMARY

178 ©The McGraw-Hill Companies, Inc., 2011

Key Concepts
LO1 Understand the potential effects of using externally reported product
costs for decision making.
♦ Basic approach to product costing involves assigning direct costs to products and allocating
manufacturing overhead costs to products.

• For financial reporting purposes, the product costs computed are used primarily for
developing inventory balances and cost of goods sold amounts, and are based on
traditional systems that allocate manufacturing costs using a handful of allocation bases
(e.g., direct labor, direct materials, or machine utilization).

• In a traditional system, once a predetermined overhead rate is calculated, it is applied as
if all overhead costs were variable with respect to the allocation base, which is not true in
most cases for two reasons:

(1) Some of the overhead items could be fixed, and reducing the number of units
produced does not result in lower fixed costs. Examples of such fixed costs include
cost of supervision, machine and plant depreciation, and miscellaneous items that do
not vary with the allocation base.

(2) Some of the overhead items could vary, but with cost drivers other than those
traditionally chosen ones.

• If managers attempt to recover the costs with a smaller number of units, they are likely
to meet resistance in the market, resulting in demand for even fewer units. With the
smaller production, the reported product costs increase even more.

Example 1: MCR Manufacturing is considering the introduction of a new memory card
reader for use with digital cameras. Estimated unit variable cost is $5 and annual fixed
costs would be $100,000. The managers decide to price the new product with an
industry-standard markup of 16 percent (based on full cost).

The sales are initially estimated to be 10,000 units. So the introductory price will be

$100,000
$17.4 = ($5 + ) × (1 + 16%).
10,000 units

From the recent marketing report, the sales forecast is revised downward to 8,000
units. To recover the production cost in a hurry, the managers set a newer (and higher)
price of


$100,000
$20.3 = ($5 + ) × (1 + 16%),
8,000 units

driving away even more would-be customers. If the managers stick with the same
costing practice (and pricing strategy), the new memory card reader will soon
disappear from the retail shelf.

• Death spiral is a phenomenon that begins by attempting to increase price to meet
higher reported product costs, losing demand, reporting still higher costs, and so on until
the firm is pricing itself out of business.

• Death spiral may occur when the demand falls while fixed costs remain the same. Death
spiral may also occur when capacity (and associated fixed overhead costs) is increased in
anticipation of growing demand in the future. Either way, the prices have to go up in
order to recover the ever higher reported product costs in a vicious cycle that eventually
drives away remaining customers.

[Assign Problems 9-34, 9-35, 9-36, 9-42, Integrative Cases 9-44, 9-45, 9-46, 9-47, 9-48]

LO2 Explain how a two-stage product costing system works.
♦ The basic approach in product costing is to allocate costs in the cost pools that record
manufacturing costs and assign, or allocate, these costs to the products or services of interest, by
using appropriate cost allocation bases or cost drivers.

• Alternative cost-allocation approaches should be evaluated based on

(1) decision usefulness, and
(2) cost-benefit considerations.

• Two-stage approach to product costing was discussed in Chapter 6 and involves the
following:

Direct costs: Assigned to
Direct materials, Cost
Direct labor objects:
Products or
Indirect costs: First stage Second stage services
Manufacturing allocation Cost pools allocation
overhead


• The first-stage cost objects (cost pools) are the overhead accounts (e.g., machine-related
costs and direct labor-related costs) captured by the cost accounting system, as shown in
Exhibit 9.4.

• The two-stage approach separates plant, or manufacturing, overhead into two or more
cost pools based on the account in which the costs were recorded.

• The allocation in the first stage permits selection of multiple cost drivers that can be
used to allocate costs to products.

• Another common choice for first-stage cost objects is to use production departments or
product lines within the plant, as shown in Exhibit 9.5.

• The allocation of overhead costs to departments is not as simple as it is when overhead
accounts are used because the costs are not necessarily recorded at the department level.

• Complexity and special handling required during production may distort the product
costs reported when the traditional costing method is used. The two-stage system, on the
other hand, allows the firm to develop product costing systems that more closely align the
allocation of costs with the use of resources.

[Assign Exercises 9-21, 9-22]

LO3 Compare and contrast plantwide and departmental allocation method.
♦ The single-stage approach was introduced in Chapter 6 and depicted below:

Direct costs: Assigned to
Direct materials, Cost
Direct labor objects:
Products or
Indirect costs: Single stage Allocated to services
Manufacturing
overhead

• The plantwide allocation method is an allocation method that uses one cost pool (of
indirect costs) for the entire plant (e.g., an entire factory, store, hospital, or other multi-
department segment of a company), as in the single stage approach mentioned earlier. It
uses one overhead allocation rate, or one set of rates, for all of the departments in a
particular plant.

• Although it is called plantwide allocation, this allocation concept can be used in both
manufacturing and nonmanufacturing organizations.


• In plantwide allocation, all overhead costs are recorded in one cost pool in the
Manufacturing Overhead Control account for the plant without regard to the department
or activity that caused them. That is,

Manufacturing overhead control xx
Materials inventory xx
Wages payable xx
Accounts payable xx
Prepaid expense xx
Accumulated depreciation xx
… xx

• A single overhead rate is used to apply overhead to products, crediting Applied
Manufacturing Overhead account. That is,

Work-in-process inventory xx
Applied manufacturing overhead xx

Example 2: A company estimated its annual overhead costs to be $240,000. The
company uses the plantwide allocation method to assign overhead costs to its two
products, AA and BB, using machine hours, budgeted to be 12,000 for the coming
year. Then the single plantwide rate would be $20 (= $240,000 ÷ 12,000 machine
hours).

In March, 400 units of product AA were produced using 800 machine hours; 100 units
of product BB were produced using 400 machine hours. Then overhead allocation
would be

To AA:
$20 per machine hour × 800 machine hours = $16,000, or
$16,000 ÷ 400 units = $40 per unit.

To BB:
$20 per machine hour × 400 machine hours = $8,000, or
$8,000 ÷ 100 units = $80 per unit.

The journal entry would be

Work-in-process inventory (AA) 16,000
Work-in-process inventory (BB) 8,000
Applied manufacturing overhead 24,000

The amount of the credit to the Applied Manufacturing Overhead account and the total
amount of the debit to Work in Process for overhead costs equal the overhead rate per


machine hour times the total number of machine-hours worked for each product.

• Companies using a single plantwide rate generally use an allocation base related to the
volume of output, such as direct labor hours, machine hours, units of output, or materials
costs.

======================
Demonstration Problem 1

ABC Manufacturing, Inc. produces three gadgets (Ace, Best, and Champ) in two departments,
Machining and Assembly. Each product requires one hour of direct labor for completion. The
following table provides production and cost data for the year.

Ace Best Champ Total
Number of units 25,000 15,000 5,000 45,000
Machine hours 2,500 1,500 2,000 6,000

Direct materials $1,000,000 $450,000 $275,000 $1,725,000
Direct labor 375,000 225,000 75,000 675,000
Overhead
Machining 900,000
Assembly 450,000
Total overhead 1,350,000
Tot costs $3,750,000

Required:
Use the plantwide allocation method to determine the unit cost for each product. The
allocation bases to choose from are
1. Machine hours.
2. Direct labor costs.

Solution:
1. The overhead allocation rate when machine hours were used as the allocation base was
$225 per machine hour (= $1,350,000 ÷ 6,000 machine hours). The unit cost report would
show the following:

Ace Best Champ
Units produced 25,000 15,000 5,000
Machine hours per unit 0.1 0.1 0.4

Direct materials $40.0 $30.0 $55.0
Direct labor 15.0 15.0 15.0
Applied overhead ($225 per machine hour) 22.5 22.5 90.0
Unit cost $77.5 $67.5 $160.0


2. The overhead allocation rate when direct hour costs were used as the allocation base was
200% (= $1,350,000 ÷ $675,000). The unit cost report would show the following:

Ace Best Champ
Units produced 25,000 15,000 5,000

Applied overhead (200% direct labor costs) 30.0 30.0 30.0
Unit cost $85.0 $75.0 $100.0

Please note that the same results can be obtained using the number of units produced as the
allocation base because each product requires one hour of direct labor for completion and the
direct labor costs are in direct proportion to the number of units produced. The overhead
allocation rate would be $30 per unit (= $1,350,000 ÷ 45,000 units) as shown above.
======================

• The department allocation method uses a separate cost pool for each department.
Each department has its own overhead allocation rate or set of rates. This is a variation of
the two-stage allocation approach in which the cost pools happen to be departments.

• If the company manufactures products that are quite similar and all use the same set of
resources, the plantwide rate is probably sufficient.

• If there are multiple products that require manufacturing facilities in many different
ways, departmental rates provide a better picture of the use of manufacturing resources
by the different products.

• The choice between a plantwide rate and departmental rates is based on the costs and
benefits of the information inherent in each system. Any incremental costs of additional
information must be justified by an increase in benefits from improved decisions.

======================
(Continued from Demonstration Problem 1)

Considering the nature of the production processes, the cost accountant of ABC Manufacturing
decided to experiment with the department-specific allocation approach and determined that the
Machining Department can use machine hours as the allocation base for overhead assignment
while the Assembly Department can use direct labor costs instead.


Required:
Use the department allocation method to determine the unit cost for each product.

Solution:
For the Machining Department, the overhead allocation rate would be $150 per machine hour
(= $900,000 ÷ 6,000 machine hours).

For the Assembly Department, the overhead allocation rate would be 66.67% (= $450,000 ÷
$675,000).

Ace Best Champ
Units produced 25,000 15,000 5,000

Applied overhead
Machining ($150 per machine hour) 15.0 15.0 60.0
Assembly (66.67% of direct labor costs) 10.0 10.0 10.0
Unit cost $80.0 $70.0 $140.0
======================

[Assign Exercises 9-21, 9-22, 9-27, 9-28, 9-29, Problems 9-37, 9-38, 9-39, 9-40, 9-41, 9-43,
Integrative Cases 9-45, 9-46, 9-47, 9-48]

LO4 Explain how activity-based costing and a two-stage product system are
related.
♦ Activity-based costing (ABC) is a two-stage product costing method that first assigns costs to
activities and then allocates them to products based on the each product’s consumption of
activities.

• The cost pools in the two-stage approach now accumulate activity-related costs.

• An activity is any discrete task that an organization undertakes to make or deliver a
product or service.

• Activity-based costing is based on the concept that products consume activities and
activities consume resources.

• Activity-based costing can be used by any organization that wants a better
understanding of the costs of the goods and services it provides, including manufacturing,
service, and even nonprofit organizations (see In Action item for a case study).


• Activity-based costing involves the following four steps:

(1) Identify the activities that consume resources and assign costs to them.
(2) Identify the cost driver(s) associated with each activity. A cost driver is any factor
that causes, or “drives,” an activity’s costs.
(3) Compute a cost rate per cost driver unit or transaction. Each activity could have
multiple cost drivers.
(4) Assign costs to products by multiplying the cost driver rate by the volume of cost
driver units consumed by the product.

• Identifying activities that use resources is the most interesting and challenging part of
the process, from which much of the value of activity-based costing comes. A cost-
benefit consideration dictates that companies identify only the most important activities.

• Many nonvalue-added activities are identified as well. These activities may be
eliminated to improve efficiency and profitability (to be discussed in Chapter 10).

• Examples of cost drivers are shown in Exhibit 9.10. Most of the cost drivers are related
either to the volume of production or to the complexity of the production or marketing
process.

• Cost drivers are selected based on three criteria:

(1) Causal relation. Ideally, choose a cost driver that causes the cost. This is the best cost
drive available.
(2) Benefits received. Choose a cost driver to assign costs in proportion to benefits
received.
(3) Reasonableness or fairness. When the first two criteria fail, assign costs on the basis
of fairness or reasonableness.

• For any indirect cost, a predetermined rate can be computed as follows:

Estimated indirect cost
Predetermined rate = .
Estimated volume of allocation base

• For activity-based costing, the first stage consists of activities. Each activity has an
associated cost pool and requires a cost driver rate using the formula above.

• The second stage in a two-stage system using activity-based costing allocates costs to
products by multiplying the cost driver rates by the number of units of the cost driver (i.e.,
volume of activities) consumed in each product. Exhibit 9.11 illustrates such a process.

• The distinctive feature of activity-based costing is that it recognizes that overhead costs
are caused by activities and that activities may not be caused solely by volume, but by
other types of activities. Cost drivers for the activities should reflect the cost incurrence
in the activity, even if cost is not caused by volume.


• Cost hierarchy represents a classification of cost drivers into general levels of activity,
volume, batch, product, etc. Four possible levels of cost hierarchy are

(1) volume-related,
(2) batch-related,
(3) product-related, and
(4) facility-related.

• Exhibit 9.12 provides example of costs and cost drivers associated with each of the four
levels.

• Not all activity-based costing systems need to have all four levels in the hierarchy, and
some can have more than four. The important factor is whether the cost drivers for the
activities reflect the cost incurred by the activity.

[Assign Exercises 9-23, 9-24, 9-25, 9-26, 9-27, 9-28, 9-29]

LO5 Compute product costs using activity-based costing.
♦ In this section, the reported product costs under activity-based costing are computed in a
comprehensive example.

• Step 1: Identify the activities. A cost accountant interviewed the production manager to
determine the major activities used in the manufacturing process.

• Step 2: Identify the cost drivers. The cost accountant interviewed production
supervisors, who in turn discussed with line employees, to determine the cost
drivers and the expected volume of each driver. The information is presented in
Exhibit 9.13.

• Step 3: Compute the cost driver rates. Once the overhead costs incurred in the facility
were determined, the cost accountant calculated the cost driver rates by dividing
overhead cost by the estimated volume for each activity identified in Step 1.
Exhibit 9.14 shows the calculation.

• Step 4: Assign costs using activity-based costing. Exhibit 9.15 shows the cost flow
diagram that assigns overhead costs to activity pools in the first stage and
allocates activity costs to products in the second stage. For each product, the
direct costs (direct materials and direct labor) are the same regardless of the
costing methods used. The difference is in the assignment of overhead costs.

• There are two ways to calculate unit cost for each product.


(1) The total cost of production for each product is calculated first. Then the total cost is
divided by the number of units produced to arrive at the unit cost. This approach is
shown in Exhibit 9.16.
(2) The cost driver rate per unit of product for each of the cost drivers can be calculated
first, which then is multiplied by the volume of activity consumption per unit of
product. The resulting sum across the cost drivers will also determine the unit cost.

======================
(Continued from Demonstration Problems 2 and 3)

The cost accountant of ABC Manufacturing attended a workshop on activity-based costing and
was impressed by the results. After consulting with the production personnel, he prepared the
following information on cost drivers and the estimated volume for each driver.

Activity Cost driver Cost driver volume Total
Machining Ace Best Champ
Setup Number of setups 125 75 50 250
Machining Machine hours 2,500 1,500 2,000 6,000
Assembly
Assembly Direct labor hours 25,000 15,000 5,000 45,000
Inspection Number of inspections 50 25 25 100

The cost accountant also determined how much overhead costs were incurred in each of the four
activities as follows:

Activity Overhead costs
Machining
Setup $150,000
Machining 750,000
Total Machining department overhead $900,000
Assembly
Assembly $360,000
Inspection 90,000
Total Assembly department overhead $450,000
Total overhead costs $1,350,000

Required:
1. Determine the cost driver rate for each activity cost pool.
2. Use the activity-based costing method to determine the unit cost for each product.
3. Summarize and comment the results.


Solution:
1.
Activity Cost drive rate
Machining
Setup $600 per setup (= $150,000 ÷ 250 setups)
Machining $125 per machine hour (= $750,000 ÷ 6,000 machine hours)
Assembly
Assembly $8 per direct labor hour (= $360,000 ÷ 45,000 direct labor hours)
Inspection $900 per inspection (= $90,000 ÷ 100 inspections)

2. In the following table, the total costs are divided by the number of units to arrive at the
unit cost for each product.

Ace Best Champ
Direct materials $1,000,000 $450,000 $275,000
Direct labor 375,000 225,000 75,000
Applied overhead
Setup ($600 per setup) $75,000 $45,000 $30,000
Machining ($125 per machine hour) 312,500 187,500 250,000
Assembly ($8 per direct labor hour) 200,000 120,000 40,000
Inspection ($900 per inspection) 45,000 22,500 22,500
Total overhead costs $632,500 $375,000 $342,500
Total costs $2,007,500 $1,050,000 $692,500
Number of units 25,000 15,000 5,000
Unit cost $80.3 $70.0 $138.5

Alternatively, the following table shows direct calculation of unit cost for each product based
on consumption of the activities for each unit of the products.

Ace Best Champ
Units produced 25,000 15,000 5,000
Number of setups per unit 0.005 0.005 0.01
Direct labor hours per unit 1 1 1
Number of inspections per unit 0.002 0.00167 0.005

Applied overhead
Setup ($600 per setup) 3.0 3.0 6.0
Machining ($125 per machine hour) 12.5 12.5 50.0
Assembly ($8 per direct labor hour) 8.0 8.0 8.0
Inspection ($900 per inspection) 1.8 1.5 4.5
Unit cost $80.3 $70.0 $138.5


3. In summary, a comparison of the methods used to calculate unit cost for each product is
presented below.

Ace Best Champ
Plantwide rate based on machine hours $77.5 $67.5 $160.0
Plantwide rate based on direct labor costs 85.0 75.0 100.0
Department rates 80.0 70.0 140.0
Activity-based costing 80.3 70.0 138.5

In this series of demonstration problems, both of the plantwide allocation methods distort
product costs. Since Champ uses four times as much machine hours as the other two products,
it inevitably receives more cost assignment from the plantwide method based on machine
hours; the opposite is the case when direct labor costs are used as the allocation base.

The department allocation method and activity-based costing produce comparable numbers
that portray consumption of resources closer to reality. Since it is less costly to implement the
department allocation method than the activity-based costing method, the managers of ABC
Manufacturing should probably use the department allocation method to handle overhead
costs in the future.
======================

[Assign Exercises 9-23, 9-24, 9-25, 9-26, 9-27, 9-28, 9-29, 9-30, 9-31, 9-32, Problem 9-34, 9-35,
9-36, 9-37, 9-38, 9-39, 9-40, 9-41, 9-43, Integrative Cases 9-45, 9-46, 9-47, 9-48]

LO6 Compare activity-based product costing to traditional department
product costing methods.
♦ As summarized in Exhibit 9.17, both the plantwide rate and the department rate systems
assumed that overhead was incurred proportionally with the volume of output. The activity-
based costing system recognized that overhead was related to activity usage, not necessarily to
the volume of output.

• Different cost allocation methods result in different estimates of how much it costs to
make a product.

• Activity-based costing provides more detailed measures of costs than do plantwide or
department allocation methods.

• Production also benefits because activity-based costing provides better information
about how much each activity costs. It helps identify cost drivers that previously were
unknown.

• Activity-based costing provides more information about product costs but requires more
record keeping.


• Installing activity-based costing requires teamwork between accounting, production,
marketing, management, and other non-accounting personnel.

[Assign Exercises 9-25, 9-26, Problem 9-34, 9-35, 9-36, 9-37, 9-38, 9-39, 9-40, 9-41, 9-42, 9-43,
Integrative Cases 9-45, 9-46, 9-47, 9-48]

LO7 Demonstrate the flow of costs through accounts using activity-based
costing.
♦ Exhibit 9.18 shows the flow of costs through accounts using activity-based costing. The
overhead accounts (both incurred and applied) are grouped by activities.

♦ Early industries were labor intensive, and much of the overhead cost was related to the support
of labor. At that time, it made sense to allocate overhead to products based on the amount of
labor component in the products.

• Nowadays, labor is still a major product cost in many companies, especially service
organizations such as consulting, law, and public accounting firms. In those cases,
overhead is often allocated to products (jobs) on the basis of the amount of labor in the
product.

• When the labor component drops in the products and overhead cost increases,
companies that continue to allocate overhead to products based on direct labor are
experiencing substantial overhead rate increases. Even small errors in cost allocation can
be magnified many times. It also sends the wrong signal that direct labor is more
expensive than it really is and drives managers to reduce the already slim labor content of
products.

• The magnitude of the overhead rate based on direct labor is of less concern when all
resources are used proportionally.

• In modern manufacturing settings, proportionality between machine hours and direct
labor hours is much less so.

♦ Costs are a function of both volume and complexity.

• Low-volume products often require more machine setups for a given level of production
output because they are produced in smaller batches.

• Low-volume product adds complexity to the operation by disrupting the production
flow of the high-volume items.

• Volume-based allocation methods allocate a high proportion of overhead costs to high-
volume products, which “subsidize” low-volume products and hide the cost effects of


keeping a large number of low-volume products. The result is that high-volume products
tend to be overcosted while low-volume products undercosted.


LO8 Apply activity-based costing to marketing and administrative services.
♦ Activity-based costing can be applied to administrative activities. The principles and methods
are the same as those discussed earlier.

• Activity-based costing in administration involves these steps:

(1) Identify the activities that consume resources.
(2) Identify the cost driver associated with each activity.
(3) Compute a cost rate per cost driver for each unit or transaction.
(4) Assign costs to the marketing or administration activity by multiplying the cost driver
rate by the volume of cost driver units consumed for that activity.

• Instead of computing the cost of a product, accountants compute the cost of performing
an administrative service.

• Time-related factors (and therefore cost drivers) are common for an administrative
function or a service business. Exhibit 9.19 shows other common cost drivers in a typical
purchasing department for various activities performed.

♦ There are three problems with identifying users of ABC.

(1) ABC means different things to different observers.
(2) ABC can be applied in parts of an organization but not everywhere.
(3) While firms may publicly announce the adoption of ABC, they are less likely to announce its
discontinuance.

• The adopters of ABC include a wide range of organizations with various sizes, from
manufacturing firms to government agencies, and from a small, regional financial service
firm to a multinational manufacturing firm. See Exhibit 9.20 for examples.

• All organizations are interested in getting better cost information for decision making,
and ABC implementation serves the purpose well.



Matching

A. Activity-based costing D. Death spiral
B. Cost driver E. Department allocation method
C. Cost hierarchy F. Plantwide allocation method

_____ 1. Represents a classification of cost drivers into general levels of activity, volume,
batch, product, etc.

_____ 2. A phenomenon that begins by attempting to increase price to meet higher reported
product costs, losing demand, reporting still higher costs, and so on until the firm is
pricing itself out of business.

_____ 3. An allocation method that uses one cost pool (of indirect costs) for the entire plant.

_____ 4. Uses a separate cost pool for each department.

_____ 5. A two-stage product costing method that first assigns costs to activities and then
allocates them to products based on the each product’s consumption of activities.

_____ 6. Any factor that causes, or “drives,” an activity’s costs.


Answers
1. C

2. D

3. F

4. E

5. A

6. B


Multiple Choice
1. Death spiral
a. Happens when managers try to set higher prices to recover increasing reported costs.
b. Occurs when capacity is reduced.
c. May happen when the market share is gaining.
d. Has to do with costs other than overhead.

2. In a two-stage cost allocation system,
a. The first stage involves assigning overhead costs to cost pools.
b. The cost pools may be departments.
c. Each cost pool requires an allocation rate.
d. All of the above.

3. One of the cost pools at Toylands Store is Personnel department that provides recruiting and
training for Sales and Administrative departments and has an estimated overhead of $45,000.
Sales department has 12 employees and Administrative department has 3. How much of the
overhead cost of the Personnel department should be allocated to the Sales department?
a. $9,000.
b. $22,000.
c. $36,000.
d. $38,000.

The following information is for questions 4 – 7.
The accountant of Toylands Manufacturing collected the following information:

Activity Overhead costs Cost driver Product X1 Product X2
Machining Dept.
Setup $200,000 Number of setups 200 50
Machining 700,000 Machine hours 20,000 15,000
Packaging Dept.
Assembly 300,000 Direct labor hours 40,000 60,000
Inspection 180,000 Number of inspections 120 60

4. If Toylands Manufacturing uses a plantwide rate based on direct labor hours to allocate
overhead costs, how much is product X1’s share of overhead?
a. $324,000.
b. $416,000.
c. $638,000.
d. $552,000.


5. If the department allocation method is used, what is the overhead rate for the Machining
department with machine hours as the allocation base?
a. $39.43 per machine hour.
b. $13.71 per machine hour.
c. $20 per machine hour.
d. $25.71 per machine hour.

6. When activity-based costing is used, what is product X2’s share of the Packaging department
overhead costs?
a. $270,000.
b. $240,000.
c. $580,000.
d. $380,000.

7. When activity-based costing is used, how much of the overhead cost is allocated to product
X1?
a. $580,000.
b. $800,000.
c. $950,000.
d. $670,000.

8. Which of the following is true of activity-based costing relative to traditional costing?
a. It requires less detailed cost measures.
b. Accounting department alone can handle all the work.
c. It needs more cost pools.
d. It is less costly to implement.

9. Activity-based costing can be beneficial to
a. Banks.
b. Nonprofit organizations.
c. Law firms

10. Low-volume products, relative to high-volume ones,
a. Entail less complexity during production.
b. Often require more machine setups.
c. Will not disrupt the production flow of high-volume items.
d. Are usually overcosted.

11. What are the steps required for activity-based costing in administration?
a. Identify activities that consume resources.
b. Identify cost drivers associated with activities.
c. Compute activity rate per cost driver.


12. Which of the following statements is incorrect?
a. Nowadays, labor is still a major product cost in many companies, especially service
organizations.
b. When the labor component drops, it is prudent to allocate overhead based on direct labor.
c. When the labor component drops, the overhead rate based on direct labor tends to
increase substantially.
d. When all resources are used proportionally, allocation of overhead based on machine
hours is acceptable.


Answers
1. a LO1

2. d LO2

3. c LO2

$45, 000
= $3,000 per employees.
12 + 3
$3,000 × 12 employees at Sales department = $36,000.

4. d LO2

$200,000 + $700,000 + $300,000 + $180,000 = $1,380,000.
$1,380, 000
= $13.8 per direct labor hour.
40, 000 + 60, 000
$13.8 × 40,000 direct labor hours = $552,000.

5. d LO2

$700,000 + $200,000 = $900,000.
$900, 000
= $25.71 per machine hour.
20, 000 + 15, 000

6. b LO4, LO5

$300, 000
= $3 per direct labor hour.
40, 000 + 60, 000
$180, 000
= $1,000 per inspection.
120 + 60
$3 per direct labor × 60,000 direct labor hours + $1,000 per inspection × 60 inspections =
$240,000.

7. b LO4, LO5

$200, 000
= $800 per setup.
200 + 50
$700, 000
= $20 per machine hour.
20, 000 + 15, 000
$800 per setup × 200 setups + $20 per machine hour × 20,000 machine hours + $3 per direct
labor hour × 40,000 direct labor hours + $1,000 per inspection × 120 inspections = $800,000.

8. c LO6


9. d LO8

10. b LO7

11. d LO8

12. b LO7


Chapter 11
Service Department and Joint Cost Allocation
Learning Objectives
1. Explain why service costs are allocated.

2. Allocate service department costs using the direct method.

3. Allocate service department costs using the step method.

4. Allocate service department costs using the reciprocal method.

5. Use the reciprocal method for decisions.

6. Explain why joint costs are allocated.

7. Allocate joint costs using the net realizable value method.

8. Allocate joint costs using the physical quantities method.

9. Explain how cost data are used in the sell-or-process-further decision.

10. Account for by-products.

11. (Appendix) Use spreadsheets to solve reciprocal cost allocation problems.


Chapter Outline
I. SERVICE DEPARTMENT COST ALLOCATION
II. METHODS OF ALLOCATING SERVICE DEPARTMENT COSTS
A. Allocation bases
B. Direct method
1. Allocate information systems department costs
2. Allocate administration department costs
3. Limitations of the direct method
C. Step method
1. Allocate service department costs
2. Limitations of the step method
D. Reciprocal method
• Allocating service department costs
E. Comparison of direct, step, and reciprocal methods
III. THE RECIPROCAL METHOD AND DECISION MAKING
IV. ALLOCATION OF JOINT COSTS
A. Joint costing defined
B. Reasons for allocating joint costs
V. JOINT COST ALLOCATION METHODS
A. Net realizable value method
• Estimation of net realizable value
B. Physical quantities method
C. Evaluation of joint cost methods
VI. DECIDING WHETHER TO SELL GOODS NOW OR PROCESS THEM
FURTHER
VII. DECIDING WHAT TO DO WITH BY-PRODUCTS
VIII. SUMMARY
IX. APPENDIX: CALCULATION OF THE RECIPROCAL METHOD USING
COMPUTER SPREADSHEETS


Key Concepts
LO1 Explain why service costs are allocated.
♦ In the first stage of the two-stage cost allocation, part of the overhead costs are incurred for
departments that do not produce the service or product directly.

• Service departments provide services to other departments in the organization.
Examples of service departments and what they do:

(1) Personnel, accounting, and purchasing departments provide services to production
departments.
(2) An information systems department provides support for information technology
support to other departments.
(3) A human resources department provides hiring and training services to other
departments.

• User departments use the functions of service departments. For example, the
production department uses the services provided by the information systems and human
resources departments.

• User departments could be other service departments or production or marketing
departments that produce or market the organization’s products.

• As shown in Exhibit 11.1, most user departments make use of all service departments.
Depending on the situation, the service departments also provide service to each other.

• An intermediate cost center is any cost center whose costs are charged to other
departments in the organization.

• A final cost center is a cost center, such as a production or marketing department,
whose costs are not allocated to another cost center.

• All organizations (service, merchandising, and manufacturing) have production or
marketing departments and service departments.

♦ Three methods to allocate service department overhead costs are:

(1) Direct method,
(2) Step method, and
(3) Reciprocal method.

• Service department costs are allocated for two purposes:

(1) To determine the cost to produce and market products or services.


(2) To encourage operating department managers to monitor service department costs
(cross-department monitoring).

• Each service department is an intermediate cost center whose costs are recorded as
incurred and then distributed to other cost centers.

• An important decision in cost allocation is to choose which allocation base to use. The
usual criteria (cause and effect, reasonableness, and fairness) are still important here.

[Assign Exercise 11-21]

LO2 Allocate service department costs using the direct method.
♦ Direct method is a cost allocation method that charges costs of service departments to user
departments without making allocations between or among service departments.

• The direct method allocates costs directly to the final users of a service, ignoring
intermediate users.

• Exhibit 11.4 is the cost flow diagram that illustrates the direct method.

• Using the direct method, there are no allocations between service departments. It
ignores the costs that the service departments themselves incur when they use services
from other departments. Cross-department monitoring is lost in that regard.

• The application of the direct method of cost allocation is shown in Exhibit 11.3.

• Exhibit 11.5 shows the flow of costs in T-accounts and the allocations to be recognized
for the departments when the direct method is used.

(1) The direct costs of service departments are first recorded in those service departments
and shown on the debit side of the service department accounts.
(2) Then service department costs are allocated to the user departments.
(3) The user departments also have direct costs (indicated as the direct overhead costs)
do not have to be allocated to the user departments because they are debited to the
department accounts when incurred.

======================

Kirby Industries has two service departments (S1 and S2) and three production departments (P1,
P2, and P3). The following table shows the costs incurred at the two service departments, as well
as the proportion of services provided by the two service departments to the other departments.


Proportion of services provided to:
Costs Service
incurred department S1 S2 P1 P2 P3
$1,000,000 S1 - 20% 30% 40% 10%
260,000 S2 40% - 20% 15% 25%

For example, service department S1 incurred $1,000,000 while providing 20 percent of its
services to service department S2, 30 percent to production department P1, 40 percent to
production department P2, and 10 percent to production department P3.

For simplicity, the direct costs incurred by the production departments are ignored.

The general manager of Kirby Industries wanted to know how the service department costs can
be allocated to the production departments in order to facilitate performance evaluation.

Required:
Allocate the service department costs to the production departments using the direct method.

Solution:
The proportion of services to be allocated has to be revised since allocations between the two
service departments are not allowed under the direct method. These are relative usages that
ignore the mutual support between the service departments.

(Revised) Proportion of services to be allocated:
Service
department S1 S2 P1 P2 P3
S1 - - 37.5%a 50.0% 12.5%
S2 - - 33.3%b 25.0% 41.7%
a
37.5% = 30% ÷ (30% + 40% + 10%).
b
33.3% = 20% ÷ (20% + 15% + 25%).

Costs allocated to:
From: S1 S2 P1 P2 P3
Costs incurred $1,000,000 $260,000 $0 $0 $0
S1 (1,000,000) 0 375,000c 500,000 125,000
S2 0 (260,000) 86,667d 65,000 108,333
Total $0 $0 $461,667 $565,000 $233,333
c
$375,000 = $1,000,000 × 37.5%.
d
$86,667 = $260,000 × 33.3%.


S1 S2
To P1: $375,000 To P1: $86,667
To P2: $500,000 To P2: $65,000
To P3: $125,000 To P3: $108,333

P1 P2 P3
From S1: $375,000 From S1: $500,000 From S1: $125,000
======================

[Assign Exercises 11-22,11-23, 11-24, 11-30, Problems 11-42, 11-43, 11-48, 11-49]

LO3 Allocate service department costs using the step method.
♦ Step method is the method of service department cost allocation that allocates some service
department costs to other service departments.

• The step method recognizes that some services are provided by one service department
to others.

• The sequence of allocation is determined so that the allocation begins with

(1) the service department that has provided the largest proportion of its total services to
other service departments, or
(2) the service department with the largest cost.

• The percentage of service costs ignored in the step allocation process is minimized by
choosing either of the allocation orders suggested.

• Once an allocation is made from a service department, no further allocations are made
back to that department.

• A service department that provides services to, and receives services from, another
service department has only one of these two relationships recognized.

• Exhibit 11.6 shows the computation of the step method.

• Exhibit 11.7 is the cost flow diagram for the step method example.

• The flow of costs through the accounts is shown in Exhibit 11.8.


• The step method may result in more reasonable allocations than the direct method
because it recognizes that some service departments use other service departments for
support.

• The step method does not recognize reciprocal services.

• The step method is not necessarily better than the direct method when both the costs
and benefits of using cost allocation are considered. A company already uses the direct
method can find it uneconomical to switch methods.

======================

The data were reproduced here.

Costs Service
$1,000,000 S1 - 20% 30% 40% 10%
260,000 S2 40% - 20% 15% 25%

Required:
Allocate the service department costs to the production departments using the step method
(where the allocation begins with the service department that provides the largest proportion
of its total services to other service departments).

Solution:
Since the service department S2 provides the largest proportion of its services to the other
service department (40 percent vs. S1’s 20 percent), S2’s costs would be allocated first to all
other departments. Once it is done, S1’s costs should not be allocated back to S2.

(Revised) Proportion of services to be allocated:
Service
S2 40.0% - 20.0% 15.0% 25.0%
S1 - - 37.5%a 50.0% 12.5%
a
37.5% = 30% ÷ (30% + 40% + 10%).

S1’s total costs to be allocated include both the $1,000,000 incurred directly by S1 and the
$104,000 allocated from S2.


Costs allocated to:
Costs incurred $1,000,000 $260,000 $0 $0 $0
S2 104,000b (260,000) 52,000 39,000 65,000
S1 (1,104,000) 0 414,000c 552,000 138,000
Total $0 $0 $466,000 $591,000 $203,000
b
$104,000 = $260,000 × 40.0%.
c
$414,000 = $1,104,000 × 37.5%.

S1 S2
$104,000 To S1: $104,000
To P1: $414,000 To P1: $52,000
To P2: $552,000 To P2: $39,000
To P3: $138,000 To P3: $65,000

P1 P2 P3
======================

[Assign Exercises 11-25, 11-26, 11-30, Problems 11-41, 11-42, 11-44, 11-46, 11-47, 11-48, 11-
49]

LO4 Allocate service department costs using the reciprocal method.
♦ Reciprocal method is the method to allocate service department costs that recognizes all
services provided by any service department, including services provided to other service
departments.

• The reciprocal method is identical to the actual process by which services are
exchanged among departments within organizations.

• The total costs of each service department are expressed as:

Total service Direct costs of Cost allocated
department = the service + to the service
costs department department


• There is a single equation for each of the service departments and there is a single
unknown (the total cost of the service department) for each service department in the
organization.

• The system of equations is solved simultaneously using matrix algebra. For this reason,
the reciprocal method is also called the simultaneous solution method.

• In the case with two service departments, define the unknowns S1 and S2 to be the total
service department costs for the two service departments. Then the simultaneous
equations can be set up as

S1= Direct costs of the first service department + α × S2, and

S2 = Direct costs of the second service department + β × S1, where

α = Proportion of services provided by the second service department to the first.
β = Proportion of services provided by the first service department to the second.

• The reciprocal method accounts for cost flows in both directions among service
departments that provide services to each other.

• Exhibit 11.9 shows the computation of the reciprocal method

• Both the step method and the direct method could understate the cost of running service
departments because these methods omit costs of certain services consumed by one
service department that were provided by other service departments.

• When there are only two service departments, simple algebra can be used to solve the
allocation problem.

• Exhibit 11.10 is the cost flow diagram for the reciprocal method.

• The flow of costs through the accounts is shown in Exhibit 11.11.

======================

The data were reproduced here.


Costs Service
$1,000,000 S1 - 20% 30% 40% 10%
260,000 S2 40% - 20% 15% 25%

Required:
Allocate the service department costs to the production departments using the reciprocal
method.

Solution:
Define S1 and S2 to be the total service department costs for departments S1 and S2,
respectively.

The service department S1 incurred $1,000,000 for providing services to other departments.
The service department S2 provided 40 percent of its services to S1. Together, the total
service department costs for S1 can be expressed as:

S1 = $1,000,000 + .4 × S2.

The service department S2 incurred $260,000 for providing services to other departments.

S2 = $260,000 + .2 × S1.

Next, insert S1 information into S2. That is,

S2 = $260,000 + .2 × [$1,000,000 + .4 × S2].

Then,

S2 = $260,000 + $200,000 + .08 × S2.
.92 × S2 = $460,000.

S2 = $500,000.
S1 = $1,200,000.

The original service proportions will apply.

Proportion of services to be allocated:
Service
S1 - 20% 30% 40% 10%
S2 40% - 20% 15% 25%


Costs allocated to:
Costs incurred $1,000,000 $260,000 $0 $0 $0
a
S1 (1,200,000) 240,000 360,000 480,000 120,000
S2 200,000b (500,000) 100,000 75,000 125,000
Total $0 $0 $460,000 $555,000 $245,000
a
$240,000 = $1,200,000 × 20.0%.
b
$200,000 = $500,000 × 40.0%.

S1 S2
To S2: $240,000 To S2: $240,000 To S1: $200,000
To P1: $360,000 To P1: $100,000
To P2: $480,000 To P2: $75,000
To S1: $200,000
To P3: $120,000 To P3: $125,000

P1 P2 P3
======================

♦ The three service department allocation methods can be compared in two ways.

• The first is to examine how each allocates costs to departments receiving services.
As shown in Exhibit 11.12, only the reciprocal method allocates costs to all departments
receiving services from other departments.

• The second way is to examine the costs each ultimately allocates to manufacturing and
marketing departments, as shown in Exhibit 11.13.

• Each method allocates the same total cost.

• The direct method results sometimes are closer to the reciprocal method results than the
results using the step method.

• All three allocation methods are arbitrary. If one production department stops using the
service of a service department, the costs saved by the firm are unlikely to be equal to the
costs allocated by any of the methods.


[Assign Exercises 11-27, 11-28, 11-29, 11-30, 11-31, 11-32, Problems 11-42, 11-45, 11-46, 11-
47, 11-49, 11-50, 11-51, 11-52]

LO5 Use the reciprocal method for decisions.
♦ The primary purpose of allocating service department costs to the production departments is to
obtain the manufacturing costs for each of the production departments for product costing and
inventory valuation.

• The cost information is also developed to assist managers in making decisions, such as
whether to outsource some or all of the activities of the service departments.

• The cost savings will depend on how much an outside vendor will charge and how
much cost in the service departments can be eliminated if outsourced.

• If there are no reciprocal services among the service departments, the cost savings are
the cost of the eliminated service department that is avoidable (= variable costs + any
avoidable fixed costs).

• If there are reciprocal services, the manager has to consider the effect of eliminating one
of the service departments on the service requirements of the remaining service
departments.

• Because the reciprocal method explicitly recognizes the use of one service department
by another, it provides an estimate of what one department costs when reciprocal service
costs are included.

======================
(Revised from Demonstration Problem 3)

Kirby Industries is considering the possibility of outsourcing the activities of service department
S1. In order to evaluate the bids from qualified vendors, Kirby’s accountant provides the
following revised data that reflect only the variable costs incurred.

Variable Proportion of services provided to:
costs Service
$300,000 S1 - 20% 30% 40% 10%
104,000 S2 40% - 20% 15% 25%

The avoidable fixed costs of running service department S1 are estimated to be $390,000.


Required:
Determine the possible cost savings from eliminating service department S1.

Solution:
Define S1 and S2 to be the variable service department costs for departments S1 and S2,
respectively.


S1 = $300,000 + .4 × S2.


S2 = $104,000 + .2 × S1.

Next, insert S1 information into S2. That is,

S2 = $104,000 + .2 × [$300,000 + .4 × S2].

Then,

S2 = $104,000 + $60,000 + .08 × S2.
.92 × S2 = $164,000.

S2 = $178,261.
S1 = $371,304.

The total variable cost of service department S1 is $371,304. This figure includes S1’s direct
cost ($300,000) and 40 percent of S2’s cost ($71,304 = $178,261 × 40%).

Out of the fixed cost of service department S1 of $700,000 (= $1,000,000 total costs -
$300,000 variable costs), $390,000 is estimated to be avoidable.

When managers of Kirby Industries evaluate bids from outside vendors, their benchmark will
be the avoidable costs which can be saved from eliminating service department S1, $761,304
(= $371,304 variable costs + $390,000 avoidable fixed costs).
======================

[Assign Exercises 11-31, 11-32, Problems 11-50, 11-51, 11-52]


LO6 Explain why joint costs are allocated.
♦ Joint cost is a cost of a manufacturing process with two or more different outputs. Joint
products are such outputs from a common input and common production process.

• The problem is whether and how to allocate the joint cost of the input to the joint
products.

• Split-off point is the stage of processing when two or more products are separated.
Processing costs incurred prior to the split-off point are the joint costs.

Example 1: The following shows a joint production process and its joint costs. After
the split-off point, two discernable joint products, A and B, emerge from the process.
The costs before the split-off point are joint; any costs spent afterwards are separable.

Split-off point

Joint product A
Joint production
Raw process
materials (with additional
materials, labor and
overhead)
Joint product B

Joint cost

• Exhibit 11.14 shows a diagram of joint cost flows.

• Cost allocations are often used to determine departmental or division costs for
measuring executive performance.

• When a single raw material is converted into products sold by two or more departments,
the cost of the raw material must be allocated to the products involved.

• Manufacturing companies must allocate joint costs to measure the inventory value of
the products that result from the joint process.

• When companies are subject to rate regulation, the allocation of joint costs can be a
significant factor in determining the regulated rates.


• Any cost allocation method contains an element of arbitrariness and must be clearly
stated before being implemented.

LO7 Allocate joint costs using the net realizable value method.
♦ The two major methods of allocating joint costs are

(1) the net realizable value method, and
(2) the physical quantities method.

♦ Net realizable value method allocates joint costs based on the proportional net realizable
value of the joint products at the split-off point.

• The net realizable value is the estimated sales value of each product at the split-off point.

• If the joint products can be sold at the split-off point, the market value or sales price
should be used for this allocation.

======================

Superior Refinery produces oil products in a joint production process. For the month of October,
$450,000 of materials, labor and overhead were added to produce the three main products: M1,
M2, and M3. The sale values were available right after the split-off point. The following diagram
shows the process.

M1
Sale value $200,000

Joint costs M2
$450,000 Sale value $300,000

M3
Sale value $500,000

Required:
Allocate the joint costs to the products using the net realizable value method.

Solution:
The cost allocation follows the proportional distribution of net realizable values.


Product Sale value Proportion Allocation
M1 $200,000 20%a $90,000b
M2 300,000 30% 135,000
M3 500,000 50% 225,000
Total $1,000,000 $450,000
a
20% = $200,000 ÷ $1,000,000.
b
$90,000 = $450,000 × 20%.
======================

• If the products require further processing before they are marketable, it may be
necessary to estimate the net realizable value at the split-off point using the estimated
net realizable value method (sometimes called the netback or workback method).

Estimated Sales price of a Additional processing costs
net realizable = final product after - necessary to prepare a
value further processing product for sale

• Under the net realizable value method, revenue dollars from any joint product are
assumed to make the same percentage contribution at the split-off point as the revenue
dollars from any other joint product. That is, each joint product gets the same gross
margin percentage.

Example 2: For Demonstration Problem 5 above, the gross margin for all the joint
products can be calculated as follows.

M1 M2 M3 Total
Sales $200,000 $300,000 $500,000 $1,000,000
Allocated joint costs 90,000 135,000 225,000 450,000
Gross margin $110,000 $165,000 $275,000 $550,000
Gross margin percentage 55% 55% 55% 55%

The gross margin percentage is the same for all the joint products when the net
realizable value method is used.

• The net realizable value method implies a matching of input costs with revenues
generated by each output.


======================

Products M1 and M2 needed further processing with additional costs before they could be
marketable. Product M3 was immediately available for sale. The following diagram shows the
process.

M1
Processing cost $120,000, Sale value $300,000

Joint costs M2
$450,000 Processing cost $80,000, Sale value $400,000

M3
Sale value $500,000

Required:
Allocate the joint costs to the products using the estimated net realizable value method.

Solution:
The estimated net realizable value is used for joint cost allocation in the same way as an
actual market value at the split-off point.

Processing Estimated net
Product Sale value cost realizable value Proportion Allocation
(1) (2) (1) – (2)
M1 $300,000 $120,000 $180,000 18%a $81,000b
M2 400,000 80,000 320,000 32% 144,000
M3 500,000 0 500,000 50% 225,000
Total $1,000,000 $450,000
a
18% = $180,000 ÷ $1,000,000.
b
$81,000 = $450,000 × 18%.
======================

[Assign Exercises 11-33, 11-34, 11-35, 11-36, 11-37, 11-38, Problems 11-53, 11-54, 11-55, 11-
56, 11-57, 11-58, 11-59, Integrative Case 11-60]

LO8 Allocate joint costs using the physical quantities method.


♦ Physical quantities method allocates joint costs based on measurement of the volume, weight,
or other physical measure of the joint products at the split-off point.

• The physical quantities method is used when

(1) output product prices are highly volatile,
(2) significant processing occurs between the split-off point and the first point of
marketability, or
(3) product prices are not set by the market.

• Many companies allocate joint costs incurred in producing oil and gas on the basis of
energy equivalent (BTU content).

======================

M2, and M3. The physical quantities of the outputs are considered relevant for cost allocation
purposes. The following diagram shows the process.

M1
15,000 units

Joint costs M2
$450,000 20,000 units

M3
25,000 units

Required:
Allocate the joint costs to the products using the physical quantities method.

Solution:
The allocation of joint costs is based on the physical units in this case.

Product Units Proportion Allocation
M1 15,000 25.0%a $112,500b
M2 20,000 33.3% 150,000
M3 25,000 41.7% 187,500
Total 60,000 $450,000


a
25% = 15,000 ÷ 60,000.
b
$112,500 = $450,000 × 25%.
======================

♦ The “jointness” of joint production process makes it impossible to separate the portion of joint
costs attributable to one product from another on a cause-and-effect basis.

• Accountants and managers realize that no one allocation method is appropriate for all
situations.

• If allocated joint costs are used for decision-making purposes, they should be used only
with full recognition of their limitations.

[Assign Exercises 11-39, 11-40, Problems 11-59, Integrative Case 11-60]

LO9 Explain how cost data are used in the sell-or-process-further decision.
♦ Managers must decide whether it is more profitable to sell the output at an intermediate stage
or to process it further.

• The relevant data to be considered are

(1) the additional revenue after further processing, and
(2) the additional costs of processing further.

• The decision rules about whether to process further are as follows.

Sell at split-off point if: Sales value at split-off > (Sales value after process – Additional
processing cost)

Process further if: Sales value at split off < (Sales value after process – Additional
processing cost)

• It is important to note that the allocation of the joint costs is irrelevant for the current
decision. The only costs and revenues relevant to the decision are those that result from it.

======================
(Continued from Demonstration Problems 5 and 6)

Products M1 and M2 can be sold immediately after the split-off point. They can also be
processed further and sold at higher prices. The following diagram shows the process.


M1
Sale value at the split-off point $200,000
Processing cost $120,000, New sale value $300,000

Joint costs M2
$450,000 Sale value at the split-off point $300,000
Processing cost $80,000, New sale value $400,000

M3
Sale value $500,000

Required:
Determine whether to sell M1 and M2 right after the split-off point, or process them further
to be sold at higher prices.

Solution:

Additional profit
Product Sale value at Sale value after Processing Margin from processing
split-off point processing cost further
(1) (2) (3) (4) = (2) – (3) (4) – (1)
M1 $200,000 $300,000 $120,000 $180,000 $(20,000)
M2 300,000 400,000 80,000 320,000 20,000

Processing M1 further will reduce profit by $20,000 while processing M2 further will
increase profit by $20,000. It is beneficial to sell M1 right after the split-off point and process
M2 further to improve revenue.
======================

[Assign Problems 11-54, 11-59, Integrative Case 11-60]

LO10 Account for by-products.
♦ By-products are outputs from a joint production process that are relatively minor in quantity
and/or value when compared to the main products.

• By-product accounting attempts to reflect the economic relationship between the by-
products and the main products with a minimum of recordkeeping for inventory valuation
purposes.

• Two common methods of accounting for by-products are:


(1) The net realizable value from sale of the by-products is deducted from the joint cost
of the main product(s). The remaining joint costs are allocated to the main products.

(2) The proceeds from sale of the by-products are treated as other revenue. All joint costs
are allocated to the main products.

• A complication can arise under both methods if the cost of processing by-products
occurs in one period but they are not sold until the next period. Companies may find it
necessary to keep an inventory of the by-product processing cost in the Additional by-
product cost account until the by-products are sold.

• Some companies expense the by-products’ costs in the period they are incurred and then
record the total revenue from by-products when they are sold, a simple approach that
technically violates the matching principle.

======================

M2, and M3. The sale values were available right after the split-off point.

Superior Refinery also produced a by-product, B, in October that was sold for $30,000. The
following diagram shows the process.

M1
Sale value $200,000

Joint costs M2
$450,000 Sale value $300,000

M3
Sale value $500,000

B
Sale value $30,000

Required:
Discuss the accounting treatments for the by-product.


Solution:
There are two methods of accounting for by-products. The first method deducts the net
realizable value from sale of the by-products from the cost of the main products, as shown
below.

Total costs to be allocated = Joint costs – Net realizable value from the by-product, or

$420,000 = $450,000 - $30,000.

Product Sale value Proportion Allocation
M1 $200,000 20%a $84,000b
M2 300,000 30% 126,000
M3 500,000 50% 210,000
Total $1,000,000 $420,000
a
20% = $200,000 ÷ $1,000,000.
b
$84,000 = $420,000 × 20%.

The second method treats the proceeds from sale of the by-product as other revenue. The
joint costs will be allocated to the main products without adjustment, as in Demonstration
Problem 5.
======================

[Assign Exercises 11-37, 11-40, Problems 11-56, 11-58]

LO11 (Appendix) Use spreadsheets to solve reciprocal cost allocation
problems.
♦ The reciprocal method requires that cost relationships be written in equation form. The method
then solves the equations for the total costs to be allocated to each department.

• For any department (both service and production), the following equation applies:

Total costs = Direct costs + Allocated costs.

• The total costs are the unknowns that will be solved.

• The analysis can be expanded to any number of service departments and production
departments.

• The set of equations can be rewritten and expressed in matrix form, and solved using
the matrix functions of a spreadsheet program such as Microsoft Excel.

• The process has three steps:


Step 1. The coefficients of the service matrix are entered.
Step 2. The inverse of the service matrix is computed.
Step 3. Multiply the inverse matrix by the vector (or array) of direct costs of the
departments.

[Assign Problem 11-45]


Matching

A. Direct method G. Service department
B. Estimated net realizable value H. Split-off point
C. Final cost center I. Step method
D. Joint cost J. User Department
E. Physical quantities method K. By-products
F. Reciprocal method L. Intermediate cost center

_____ 1. The method to allocate service department costs that recognizes all services provided
by any service department, including services provided to other service departments.

_____ 2. The stage of processing when two or more products are separated.

_____ 3. Allocates joint costs based on measurement of the volume, weight, or other physical
measure of the joint products at the split-off point.

_____ 4. Outputs from a joint production process that are relatively minor in quantity and/or
value when compared to the main products.

_____ 5. Sales price of a final product Additional processing costs necessary to prepare
after further processing - a product for sale

_____ 6. The method of service department cost allocation that allocates some service
department costs to other service departments.

_____ 7. A cost center, such as a production or marketing department, whose costs are not
allocated to another cost center.

_____ 8. Uses the functions of service departments.

_____ 9. A cost of a manufacturing process with two or more different outputs.

_____ 10. A cost allocation method that charges costs of service departments to user
departments without making allocations between or among service departments.

_____ 11. Any cost center whose costs are charged to other departments in the organization.

_____ 12. Provides services to other departments in the organization.


Answers
1. F

2. H

3. E

4. K

5. B

6. I

7. C

8. J

9. D

10. A

11. L

12. G


Multiple Choice
1. Which of the following statements is incorrect?
a. Service departments provide services to other departments.
b. Service departments are not the same as user departments.
c. An intermediate cost center is any cost center whose costs are charged to other
departments.
d. A final cost center is any cost center whose costs are not allocated to other cost centers.

A company has two service departments (S1 and S2) and two manufacturing divisions (M1 and
M2). The following information is available.

Costs Service
incurred department S1 S2 M1 M2
$290,000 S1 - 20% 30% 50%
500,000 S2 50% - 20% 30%

2. Using the direct method, what proportion of S1’s costs will be allocated to M2?
a. 20%.
b. 37.5%.
c. 50%.
d. 62.5%.

3. Using the direct method, how much of the service department costs will be allocated to M1?
a. $195,250.
b. $205,750.
c. $308,750.
d. $326,450.

4. Using the step method, how much of the service department costs will be allocated to M1?
a. $243,000.
b. $265,700.
c. $295,400.
d. $302,500.

5. Using the reciprocal method, how should the total service department costs of S1 be
expressed?
a. S1 = $290,000 + .5 × S2.
b. S1 = $290,000 + .2 × S2.
c. S1 = $290,000 + .3 × S2.
d. S1 = $500,000 + .5 × S2.


6. Using the reciprocal method, how much of the service department costs will be allocated to
M1?
a. $241,000.
b. $286,000.
c. $304,000.
d. $403,000.

A joint production process that cost $240,000 generated two main products. P1 has 15,000 units
and can be sold at split-off point for $300,000. P2 has 25,000 units and can be sold at split-off
point for $200,000. A by-product can be sold for $30,000.

7. Using the net realizable value method, how much of the joint costs would be allocated to P1?
a. $120,000.
b. $144,000.
c. $156,000.
d. $183,000.

8. Using the physical quantities method, how much of the joint costs would be allocated to P1?
a. $90,000.
b. $120,000.
c. $150,000.
d. $180,000.

9. If the sale value of the by-product is deducted from the joint costs of the main products, how
much is P1’s share of the total costs?
a. $126,000.
b. $216,000.
c. $105,000.
d. $184,000.

10. The relevant data for deciding whether to process further are
a. Additional revenue after further processing.
b. Joint costs.
c. Additional costs of processing further.
d. Both a and c.

11. Which of the following is not a service department?
a. Human resources.
b. Accounting.
c. Mailroom.
d. Production.


12. Which of the following allocation methods does not consider any mutual support among
service departments?
a. Step method.
b. Direct method.
c. Reciprocal method.
d. None of the above.


Answers
1. b LO1

2. d LO2

62.5% = 50% ÷ (30% + 50%).

3. c LO2

30% 20%
$308,750 = $290,000 × + $500,000 × .
30% + 50% 20% + 30%

4. d LO3

Using the step method, S2’s costs will be allocated first.
30%
$302,500 = $500,000 × 20% + [$290,000 + $500,000 × 50%] × .
30% + 50%

5. a LO4

6. c LO4

S1 = $290,000 + .5 × S2.
S2 = $500,000 + .2 × S1.
S1 = $600,000 and S2 = $620,000.
$304,000 = $600,000 × 30% + $620,000 × 20%.

7. b LO7

$300, 000
$144,000 = $240,000 × .
$300,000 + $200,000

8. a LO8

15, 000
$90,000 = $240,000 × .
15,000 + 25,000

9. a LO10

$300, 000
$126,000 = ($240,000 - $30,000) × .
$300,000 + $200,000

10. d LO9


11. d LO1

12. b LO2, LO3, LO4


Chapter 13
Planning and Budgeting
Learning Objectives
1. Understand the role of budgets in overall organization plans.

2. Understand the importance of people in the budgeting process.

3. Estimate sales.

4. Develop production and cost budgets.

5. Estimate cash flows.

6. Develop budgeted financial statements.

7. Explain budgeting in merchandising and service organizations.

8. Explain why ethical issues arise in budgeting.

9. Explain how to use sensitivity analysis to budget under uncertainty.


Chapter Outline
I. HOW STRATEGIC PLANNING INCREASES COMPETITIVENESS
II. OVERALL PLAN
A. Organization goals
B. Strategic long-range profit plan
C. Master budget (Tactical short-range profit plan): Tying the strategic plan to the
operating plan
III. HUMAN ELEMENT IN BUDGETING
♦ Value of employee participation
IV. DEVELOPING THE MASTER BUDGET: WHERE TO START?
♦ Sales forecasting
1. Sales staff
2. Market researchers
3. Delphi technique
4. Trend analysis
5. Econometric model
V. COMPREHENSIVE ILLUSTRATION
A. Forecasting production
B. Forecasting production costs
1. Direct materials
2. Direct labor
3. Overhead
C. Completing the budgeted cost of goods sold
D. Revising the initial budget
VI. MARKETING AND ADMINISTRATIVE BUDGET
VII. PULLING IT TOGETHER INTO THE INCOME STATEMENT
VIII. KEY RELATIONSHIPS: THE SALES CYCLE
IX. USING CASH FLOW BUDGETS TO ESTIMATE CASH NEEDS
♦ Multiperiod Cash Flows
X. PLANNING FOR THE ASSETS AND LIABILITIES ON THE BUDGETED
BALANCE SHEETS
XI. BIG PICTURE: HOW IT ALL FITS TOGETHER
XII. BUDGETING IN RETAIL AND WHOLESALE ORGANIZATIONS
XIII. BUDGETING IN SERVICE ORGANIZATIONS
XIV. ETHICAL PROBLEMS IN BUDGETING
XV. BUDGETING UNDER UNCERTAINTY
XVI. SUMMARY


Accy121 finalexaminstrmanualchs9 11_13_16_appendix

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