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Service Department and Joint Cost Allocation Chapter 11 Power. Point Authors: Susan Coomer Galbreath, Ph. D. , CPA Jon A. Booker, Ph. D. , CPA, CIA Cynthia J. Rooney, Ph. D. , CPA Copyright © 2017 by Mc. Graw-Hill Education. All rights reserved.

11 -3 Learning Objectives LO 11 -1 LO 11 -2 LO 11 -3 LO 11 -4 LO 11 -5 LO 11 -6 LO 11 -7 LO 11 -8 LO 11 -9 Explain why service costs are allocated. Allocate service department costs using the direct method. Allocate service department costs using the step method. Allocate service department costs using the reciprocal method. Use the reciprocal approach for outsourcing decisions. Explain why joint costs are allocated. Allocate joint costs using the net realizable value method. Allocate joint costs using the physical quantities method. Explain how cost data are used in the sell-or-process-further decision. LO 11 -10 Account for by-products. LO 11 -11(Appendix) Use spreadsheets to solve reciprocal cost allocation problems.

LO 11 -1 11 -4 Service Department Cost Allocation LO 11 -1 Explain why service costs are allocated. Service departments provide services to other departments. For example, an information systems department is a service department that provides information systems support to other departments, and 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.

LO 11 -1 11 -5 Service Department Cost Allocation Service and User Departments – Carlyle Coal Company

LO 11 -1 11 -6 Service Department Cost Allocation Basic Data for Service Department Cost Association Carlyle Coal Company Departmental Costs $800, 000

LO 11 -2 11 -7 Cost Allocation: Direct Method LO 11 -2 Allocate service department costs using the direct method. • Direct method: Charges costs of service departments to user departments without making allocations among service departments.

LO 11 -2 11 -8 Cost Allocation: Direct Method Basic Information of Direct Method Allocation: Carlyle Coal Company

LO 11 -2 11 -9 Cost Allocation: Direct Method Pacific Mine (P 2) 20. 0% = 20, 000 hours ÷ (20, 000 hours + 80, 000 hours) 62. 5% = 5, 000 employees ÷ (5, 000 employees + 3, 000 employees) c $160, 000 = 20% × $800, 000 d $3, 125, 000 = 62. 5% × $5, 000 a b

LO 11 -3 11 -10 Cost Allocation: Step Method LO 11 -3 Allocate service department costs using the step method. • The step method allocates some service department costs to other service departments. • Once an allocation is made from a service department no further allocations are made back to that service department. • Generally, allocate in order of proportion of services provided to other service departments.

LO 11 -3 11 -11 Cost Allocation: Step Method Cost Flow Diagram: Step Method – Carlyle Coal Company

LO 11 -3 11 -12 Cost Allocation: Step Method Service Department Cost Allocation Direct Cost Service Dept. : (S 1) (S 2) $ 800, 000 5, 000 Percent Applicable to (S 1) 0. 0% (S 2) (P 1) (P 2) Total 50. 0%a 0. 0% 10. 0%b 62. 5%d 40. 0%c 37. 5%e 100. 0% 50. 0% = 100, 000 hours ÷ (100, 000 hours + 20, 000 hours + 80, 000 hours) 10. 0% = 20, 000 hours ÷ (100, 000 hours + 20, 000 hours + 80, 000 hours) c 40. 0% = 80, 000 hours ÷ (100, 000 hours + 20, 000 hours + 80, 000 hours d 62. 5% = 5, 000 employees ÷ (5, 000 employees + 3, 000 employees) e 37. 5% = 3, 000 employees ÷ (5, 000 employees + 3, 000 employees) a b

LO 11 -3 11 -13 Cost Allocation: Step Method Service Department Cost Allocation To From Dept. costs (S 1) (S 2) (S 1) $800, 000 (800, 000) -0$ -0 - (S 2) $5, 000 400, 000 f (5, 400, 000) $ -0 - 50. 0% × $800, 000 g 10. 0% × $800, 000 h 40. 0% × $800, 000 I 62. 5% × $5, 400, 000 j 37. 5% × $5, 400, 000 k $5, 800, 000 of service department costs were ultimately allocated to production departments. f (P 1) $ (P 2) -0 - $ -080, 000 g 320, 000 h 3, 375, 000 i 2, 025, 000 j $3, 455, 000 $2, 345, 000 Total $5, 800, 000 k

LO 11 -4 11 -14 Cost Allocation: Reciprocal Method LO 11 -4 Allocate service department costs using the reciprocal method. • The reciprocal method recognizes all services provided by any service department, including services provided to other service departments. • It accounts for cost flows among service departments providing services to each other. • It requires a simultaneous equation solution.

LO 11 -4 11 -15 Cost Allocation: Reciprocal Method Cost Flow Diagram: Reciprocal Method – Carlyle Coal Company

LO 11 -4 11 -16 Cost Allocation: Reciprocal Method 1. Write the costs of each service department in equation form. Total Service Department costs = Direct costs of the Service Department + Costs allocated to the Service Department 2. Solve equations simultaneously using matrix algebra.

LO 11 -4 11 -17 Cost Allocation: Reciprocal Method Total Service Department costs = Direct cost of the Service Department + Costs allocated to the Service Department S 1 = $ 800, 000 + 0. 20 S 2 = $5, 000 + 0. 50 S 1 Substituting the first equation into the second yields: S 2 = $5, 000 + 0. 50($800, 000 + 0. 20 S 2) S 2 = $5, 000 + $400, 000 + 0. 10 S 2 0. 9 S 2 = $5, 400, 000 S 2 = $6, 000 Substituting the value of S 2 back into the first equation gives: S 1 = $800, 000 + 0. 20($6, 000) S 1 = $2, 000

LO 11 -4 11 -18 Cost Allocation: Reciprocal Method Service Department Cost Allocation Service Dept. : (S 1) (S 2) Percent Applicable to Total Cost (S 1) (S 2) (P 1) (P 2) Total $2, 000 6, 000 0. 0% 20. 0%d 50. 0%a 0. 0% 10. 0%b 50. 0%e 40. 0%c 30. 0%f 100. 0% 50. 0% = 100, 000 hours ÷ (100, 000 hours + 20, 000 hours + 80, 000 hours) 10. 0% = 20, 000 hours ÷ (100, 000 hours + 20, 000 hours + 80, 000 hours) c 40. 0% = 80, 000 hours ÷ (100, 000 hours + 20, 000 hours + 80, 000 hours) d 20. 0% = 2, 000 employees ÷ (2, 000 employees + 5, 000 employees + 3, 000 employees) e 50. 0% = 5, 000 employees ÷ (2, 000 employees + 5, 000 employees + 3, 000 employees) f 30. 0% = 3, 000 employees ÷ (2, 000 employees + 5, 000 employees + 3, 000 employees) a b

LO 11 -4 11 -19 Cost Allocation: Reciprocal Method Service Department Cost Allocation To From (S 1) (S 2) (P 1) (P 2) Total $ 800, 000 $5, 000 $ -0 - $5, 800, 000 i Direct costs (2, 000)a 1, 000 b 200, 000 c 800, 000 d (S 1) 1, 200, 000 e (6, 000)f 3, 000 g 1, 800, 000 h (S 2) $ -0 - $3, 200, 000 $2, 600, 000 $5, 800, 000 i a Total costs of S 1 b Costs allocated from S 1 (50% × $2, 000) c 10. 0% × $2, 000 d 40. 0% × $2, 000 e Costs allocated from S 2 (20% × $6, 000) f Total costs of S 2 g 50% × $6, 000 h 30% × $6, 000 I $5, 800, 000 of service department costs were ultimately allocated to production departments.

LO 11 -4 11 -20 Cost Allocation: Reciprocal Method Comparison of Direct, Step, and Reciprocal Methods Method Direct Step Reciprocal Hilltop Mine Pacific Mine Total $3, 285, 000 $2, 515, 000 $5, 800, 000 3, 455, 000 2, 345, 000 5, 800, 000 3, 200, 000 2, 600, 000 5, 800, 000

LO 11 -5 The Reciprocal Method and Decision Making 11 -21 LO 11 -5 Use the reciprocal approach for outsourcing decisions. • Suppose that the variable cost in Information Services (S 1) is $200, 000 (out of the total of $800, 000) and the variable cost in Administration (S 2) is $3, 500, 000 (out of $5, 000). • Let's repeat the reciprocal cost analysis substituting the variable costs from the total costs.

LO 11 -5 The Reciprocal Method and Decision Making 11 -22 Total Service Department costs = Direct cost of the Service Department + Costs allocated to the Service Department S 1 = $ 200, 000 + 0. 20 S 2 = $3, 500, 000 + 0. 50 S 1 Substituting the first equation into the second yields: S 2 = $3, 500, 000 + 0. 50($200, 000 + 0. 20 S 2) S 2 = $3, 500, 000 + $100, 000 + 0. 10 S 2 0. 9 S 2 = $3, 600, 000 S 2 = $4, 000 Substituting the value of S 2 back into the first equation gives: S 1 = $200, 000 + 0. 20($4, 000) S 1 = $1, 000

LO 11 -5 The Reciprocal Method and Decision Making 11 -23 • The total variable cost of Information Services, when you consider the use of Administration by Information Services is $1, 000. • The total cost savings that would come from eliminating Information Services are the $1, 000 variable costs plus any avoidable fixed costs.

LO 11 -6 11 -24 Allocation of Joint Costs LO 11 -6 Explain why joint costs are allocated. Joint cost is the cost of a manufacturing process with two or more outputs. • Joint Products • Outputs from a common input and common production process • Split-Off point • Stage of processing that separates two or more products

LO 11 -6 11 -25 Allocation of Joint Costs Split-off point Hi-grade coal: 15, 000 units Sales value: $300, 000 Mining costs $270, 000 Lo-grade coal: 30, 000 units Sales value: $450, 000

LO 11 -6 11 -26 Allocation of Joint Costs • Evaluating executive performance • Determining the inventory value • Net realizable value method • Physical quantities method

LO 11 -7 11 -27 Joint Cost Allocation Methods LO 11 -7 Allocate joint costs using the net realizable value method. • Net realizable value method: Joint cost allocation based on the proportional values of the products at the split-off point. • Net realizable value (NRV): Sales value of each product at the split-off point. • Estimated net realizable value: Sales price of a final product minus additional processing costs necessary to prepare a product for sale.

LO 11 -7 11 -28 Net Realizable Value Method Carlyle Coal Company Joint Allocation – NRV Method (no additional processing costs)

LO 11 -7 11 -29 Net Realizable Value Method Carlyle Coal Company For the Month of March

LO 11 -7 11 -30 Estimating NRV When no sales value exists for outputs at the split-off point, the estimated NRV should be determined. Split-off Further Processing of Coal: point Cost Flows – Carlyle Coal Company Hi-grade coal: 15, 000 units Sales value: $300, 000 Mining costs $270, 000 Lo- to Mid-grade coal: 30, 000 units $50, 000 processing cost Sales value: $550, 000

LO 11 -7 11 -31 Estimating NRV Carlyle Coal Company For the Month of March

LO 11 -8 11 -32 Physical Quantities Method LO 11 -8 Allocate joint costs using the physical quantities method. Joint cost allocation is based on measurement of the volume, weight, or other physical measure of the joint products at the split-off point.

LO 11 -8 11 -33 Physical Quantities Method • Output product prices are volatile. • Significant processing occurs between the split-off point and the first point of marketability. • Product prices are not set by the market.

LO 11 -8 11 -34 Physical Quantities Method Carlyle Coal Company For the Month of March

LO 11 -9 11 -35 Sell or Process Further LO 11 -9 Explain how cost data are used in the sell-or-process-further decision. • Suppose CCC can sell Lo-grade coal for $450, 000 at the split-off point or process it further to make mid-grade coal. • Mid-grade coal would sell for $550, 000 and additional processing costs would be $50, 000. Additional revenue: Additional cost: $100, 000 $ 50, 000 ?

LO 11 -9 11 -36 Sell or Process Further Differential Analysis Carlyle Coal Company Sell Process Differential Lo-Grade Further Revenue/ Coal (Mid-Grade) Costs Revenues Less: Separate processing costs Margin $450, 000 -0$450, 000 $550, 000 $500, 000 Net gain from processing further $100, 000 50, 000 $ 50, 000

LO 11 -10 Deciding What to Do with By. Products LO 11 -10 Account for by-products. • By-products are outputs of joint production processes that are relatively minor in quantity or value. • Method 1: The net realizable value from sale of the by-products is deducted from the joint costs before allocation to the main products. • Method 2: The proceeds from sale of the by-product are treated as other revenue. 11 -37

LO 11 -10 11 -38 By-Products – Method One Carlyle Coal Company For the Month of March Hi-Grade Lo-Grade Sales value Less: Additional processing costs Net realizable value at split-off point Deduct: Sales value of by-producta Allocated remaining joint costsa Gross margin as a percent of sales $300, 000 -0102, 000 b $198, 000 66% Joint costs adjusted for sales value of by-product (dust) ($300, 000 ÷ $750, 000) or 40% × ($270, 000 – $15, 000) c ($450, 000 ÷ $750, 000) or 60% × ($270, 000 – $15, 000) a b $450, 000 -0153, 000 c $297, 000 66% Dust Total $15, 000 -0$15, 000 -0 -00% $765, 000 -0$765, 000 15, 000 255, 000 $495, 000 65%

LO 11 -10 11 -39 By-Products – Method Two Carlyle Coal Company For the Month of March Hi-Grade Lo-Grade Sales value Less: Additional processing costs Net realizable value at split-off point Allocated joint costsa Gross margin as a percent of sales $300, 000 -0$300, 000 108, 000 b $192, 000 64% Joint costs adjusted for sales value of by-product (dust) ($300, 000 ÷ $750, 000) or 40% × $270, 000 c ($450, 000 ÷ $750, 000) or 60% × $270, 000 a b $450, 000 -0$450, 000 162, 000 c $288, 000 64% Dust Total $15, 000 -0$15, 000 100% $765, 000 -0$765, 000 270, 000 $495, 000 65%

LO 11 -11 Appendix: Calculation of the Reciprocal Method Using Spreadsheets LO 11 -11 (Appendix) Use spreadsheets to solve reciprocal cost allocation problems. • For any department, we can state the equation: Total costs = Direct costs + Allocated costs • Equations can be expressed in matrix form and solved using the matrix functions of a spreadsheet program such as Microsoft Excel®. 11 -40

LO 11 -11 Appendix: Calculation of the Reciprocal Method Using Spreadsheets Series of departmental cost equations 11 -41

LO 11 -11 Appendix: Calculation of the Reciprocal Method Using Spreadsheets Service Department Cost Allocation Using the Reciprocal Method: Spreadsheet Solution 11 -42

LO 11 -11 Appendix: Calculation of the Reciprocal Method Using Spreadsheets Service Department Cost Allocation Using the Reciprocal Method: Spreadsheet Solution 11 -43

LO 11 -11 Appendix: Calculation of the Reciprocal Method Using Spreadsheets Service Department Cost Allocation Using the Reciprocal Method: Spreadsheet Solution 11 -44

11 -45 End of Chapter 11