MFHP Financial Mgmt Toolkit Indirect Costs: Direct Allocation Method

Management decisions concerning whether to sell a

product at the split-off point or to process the product further fall into a category referred to as relevant, differential or incremental cost decisions. The key to the correct decision is to only consider the differences between the alternative courses of action. Following this decision rule, the joint costs are

not relevant because they will not be different regardless of the decision to sell at the split-off point or to process the products beyond this point. The

decision should be based on a comparison of the additional market value created by further processing, with the additional cost required beyond the split-off

point.

• Some observers say this is fair, while others

  voice the opposite viewpoint.

• Direct allocation doesn’t allow you to allocate support department costs to other support departments.
• Using a single budgeted rate, rather than either a single actual rate or dual rate (Exhibit 6-11) will normalize the service costs

  allocations, provide more timely costing and aid in evaluating the service departments.

• These include support services such as human resources and accounting.
• Equations 3 and 4 describe the “reciprocated costs” of S1 and S2.
• This problem is eliminated by using the single budgeted rate method illustrated below.

After the simultaneous equations have been solved, the allocations to the producing departments are easily determined by hand as follows. The denominator for the proportions of service provided from S1 to P1 and P2 is 900, not 950 and the denominator for the proportions of service provided from

S2 to P1 and P2 is 250 not 300. This is because the self service hours are ignored as well as the 20 hours provided to Power. Since the Power Department has already been closed, no costs are allocated from Maintenance to Power. To illustrate the methods, it’s convenient to convert the allocation bases from hours consumed by each department to percentages of the total base for each service department (see Figure 2). To keep it simple, neither S1 nor S2 consumes its own services.

Activity-Based Management Vs. Functional-Based Management

In addition, the

proportions (Kji) in both sets of equations are different for the same reason. The proportions reflect all of the relationships in the reciprocal

method, instead of only part of the relationships as in the step-down method. The reciprocal method is more accurate than the other two methods because it fully recognizes self services and reciprocal services between service https://turbo-tax.org/public-accounting-vs-private-accounting/ departments. However, this

method is more involved because it requires the solution to simultaneous equations. The reciprocal method includes three steps as follows. Although issues concerning the equitableness of various types of taxes are outside the scope of a cost accounting course, similar controversial issues arise with regard to cost

allocations within organizations.

In

addition to allocating costs for inventory purposes, management needs accurate cost allocations for a make or buy decision. The company has

always generated its’ own electric power since the plant was built in a rather isolated area of the northwest. However, a new public utility has

recently offered to provide electric power to the plant for 4.5 cents per kilowatt hour. As a result the firm’s management needs to know how much

cost could be avoided if the electric power plant were closed, and how much electricity would be needed if it were purchased externally.

AccountingTools

The example presented below illustrates this concept. A third method, referred to as activity based product costing, also involves a two stage allocation process where the first stage is essentially the same as in the

traditional two stage approach. However, in the second stage of the ABC approach, overhead costs are separated into cost pools so that different types

of costs can be traced to products more accurately using different types of activity measures. While some of the activity measures may be related to

production volume, other non-production volume related activity measures are also used.

The company has two service departments and two operating departments. Which stage I cost allocation methods consider reciprocal services? How is the sequence of the service departmental cost allocations determined in the step-down method? Joint costs can be accounted for in a variety of ways. Another possible alternative is not to allocate the joint costs. The allocations for the step-down method are presented in Exhibit 6-5.

Method

This approach involves allocating the joint costs to products in proportion to these estimated sales values. It provides an alternative to the previous approach when the products

can not be sold at the split-off point, i.e., without further processing. The net realizable value method implies that the increase in sales value from the split-off point to the time of sale is only equal to the after split-off

costs.

This allows for better decision-making when determining how much should be spent on different business areas. OnEntrepreneur is an online magazine for Entrepreneurs, startups and business owners focusing on business, marketing, investing, technology, entrepreneurship, leadership and much more. Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens»publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa. Describe the types of relationships between the departments within an organization. The following symbols are used to develop equations for each approach.

THE RECIPROCAL METHOD

The direct allocation of costs clearly identifies which specific objects are incurring the costs. This transparency can help in decision-making, as it allows for a better understanding of the cost structure and facilitates the identification of cost-saving opportunities. Circle the letter of the best answer for each of the following questions.

Since it is not clear how these allocations should be performed to obtain more accurate product costs, we

will examine three possible alternative methods. The Cutright Company has a small factory with two service departments and two producing departments. The service departments, Power and Maintenance provide support to the producing

departments, Cutting and Assembly, to each other and also use some of their own services. These estimates are used to

develop predetermined departmental overhead rates for the Cutting and Assembly departments. A method used in allocating the costs of manufacturing service departments (factory administration, maintenance, etc.) directly to the producing departments in the factory. Under this method, no service department cost will be allocated to another service department.

Since this is not likely to be an accurate assumption concerning the values added by the separate joint and after split-off processes, the NRV

estimates of values at the split-off point are likely to be misstated. However, if there are no identifiable sales values at the split-off point, this method

seems to provide the next best alternative. The direct method allocates costs of each of the service departments to each operating department based on each department’s share of the allocation base.

However, the allocations for these methods show the dilemma that system designers face when there are no identifiable values at the point of separation. If we assume that the raw chicken can not be sold, then the net realizable value method appears to be the next best choice. 3) Solve the equations developed in [2] to determine the allocations to the producing departments.