Ch. 11 Lecture notes including Demo cases with solutions.

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. User

departments use the services of service departments.

• An information systems department is a service department that provides support for

information systems to other departments. A human resources department provides hiring and
training services to other 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 the allocation base that will be used. The criteria: cause and
effect, reasonableness, and fairness, are still important here.

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 use of the direct method of cost allocation is shown in Exhibit 11.3.

• Only overhead must be allocated. Direct labor, supplies, and direct departmental costs are
charged directly to the operating departments.

• 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.

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Demonstration Case 1

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 service
departments are not allowed under the direct method. These are relative usages that ignore
the mutual support between service departments.
 Proportion of services to be allocated:
Service
department S1 S2 P1 P2 P3
a
S1 - - 37.5% 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

P1 P2 P3

======================
[Assigned Exercise11-23]

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.

• Allocations usually begin from the service department that has provided the largest proportion
of its total services to other service departments.

• Sometimes, the allocation begins from the service department with the largest cost.

• The percentage of services ignored in the step allocation process is minimized by choosing the
allocation order 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.

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

• The step method may result in more reasonable allocations then 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.

======================
Demonstration Case 2
(Continued from Demonstration Case 1)

The data were reproduced here.

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%

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

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.

Proportion of services to be allocated:

Service
department S1 S2 P1 P2 P3
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:
From: S1 S2 P1 P2 P3
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

P1 P2 P3

[Assigned Exercise 11-24]

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.

• 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 might 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.

Demonstration Case 3
(Continued from Demonstration Case1)

The data were reproduced here.

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%

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.
The service department S1 provided 20 percent of its services to S2. Together, the total
service department costs for S2 can be expressed as:

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
department S1 S2 P1 P2 P3
S1 - 20% 30% 40% 10%
S2 40% - 20% 15% 25%
Costs allocated to:
From: S1 S2 P1 P2 P3
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

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.

[Assigned Exercises11-26]

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.

• 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 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.

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.
Demonstration Case 4

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 net Sales price of a Additional processing costs

realizable value = final product after - necessary to prepare a product
further processing 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: For Demonstration Case 4 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.
======================

Demonstration Case 5
(Continued from Demonstration Case 4)

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.

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
Solution:
The estimated net realizable value is used for joint cost allocation in the same say as an
actual market value at the split-off point.
 a
18% = $180,000 ÷ $1,000,000.
b
$81,000 = $450,000 × 18%.

======================
[Assigned Exercise 11-30]

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).
======================
Demonstration Case 6
(Continued from Demonstration Case 4)

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 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.

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

[Assigned Exercise 11-36]

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.

======================
Demonstration Case 7
(Continued from Demonstration Cases 4 and 5)

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.

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
Solution:
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.

======================
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.

======================
Demonstration Case 8
(Continued from Demonstration Case 4)

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.

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
Case 4.