Chapter 12: Cost Allocation: Service Departments and Joint Product Costs

Summary

This chapter introduces the objectives, concepts, and methods of cost allocation. There are two main cost allocation applications—departmental cost and joint product costing. Most important, the objectives and methods for cost allocation are determined based on the firm’s strategy. Cost allocation is concerned with strategy in four key ways: (1) to determine accurate departmental and product costs as a basis for evaluating the departments’ cost efficiency and profitability of different products, (2) to motivate managers to work hard, (3) to provide the proper incentive for managers to achieve the firm’s goals, and (4) to provide a fair basis for rewarding managers for their effort.

Ethical issues often arise in cost allocation when managers must choose between alternative allocation methods. The manager must choose between methods that might decrease the cost of one product, customer, or business unit at the expense of increased costs for another product, customer, or unit.

Departmental cost allocation is performed in three phases: (1) trace all direct costs and allocate overhead to service and production departments, (2) allocate service department costs to production departments, and (3) allocate production department costs to products. The second phase is the most complex. Service department costs can be allocated to production departments using three methods—the direct method, the step method, and the reciprocal method. The three methods differ in the way they deal with service flows among service departments. The direct method ignores these flows, the step method includes some of them, and the reciprocal method includes all. For this reason, the reciprocal method is preferred.

A number of implementation issues arise when applying cost allocation methods including the strategic and ethical issues of the cost allocation. It is also important to allocate variable and fixed costs separately (in a process called dual allocation), to use budgeted rather than actual amounts in the allocation, and to consider alternative allocation methods when the result of an allocation to a department is a cost that is greater than the department could purchase the item from an outside entity.

The need for joint product costing arises when two or more products are made simultaneously in a given manufacturing process. The three methods for costing joint products are the (1) the physical measure method, (2) sales value at split-off method, and (3) net realizable value method. The physical measure method is the simplest to use but also has a significant disadvantage. Because the allocation ignores sales value, the gross margins of joint products determined using the physical measure method can differ in significant and unreasonable ways. In contrast, the sales value and net realizable value methods tend to result in similar gross margins among the joint products. The sales value at split-off method is used when sales value at split-off is known; otherwise the net realizable value is used.