Therefore, the joint cost allocations should not imply that trueprofitability has been obtained. Critics rebut the previous argument by pointing out that this method sometimes produces a negative cost allocation to some ofthe less profitable products (See the example below). Certainly, approximations of the true costs are better than these confusing cross-subsidies. Departmental overhead rate allocations are illustrated in the top section of Exhibit 6-15. The notes to the table show how the overhead rates werecalculated in each case. To show how a single plant wide overhead rate can distort product costs, assume that the firm in Example 6-1 produces two products, X1 and X2.
Calculating Fully Reciprocated Costs
The underlying concepts of cost allocations relate to the purposes of assigning costs to cost objects as well as the principles, or supporting logic for the cost allocation methods chosen. Total maintenance cost can be calculated as$8,000 department cost + $1,429 (7,145 x 20%) allocated fromadministration for a total of $9,429. This approach is best used where some service cost centres provide services to other service cost centres, but these services are not reciprocated. Cost centre C serves centres D and E, but D and E do not reciprocate by serving C.
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(See the note under the table for these calculations.) These values do not change, regardless of the joint costallocation method, although the individual gross profit amounts vary widely across the four methods. Clearly, selling both white and dark fried chicken ismore profitable than selling either product at the point of separation. A complete picture of the reciprocal allocations appears in Exhibit 6-7. There may appear to be somedouble counting in the Power and Maintenance Departments, but this a normal result when solving simultaneous equations. When we compare the original directcosts before allocations to the producing department costs after all allocations, it is clear that the double counting has not caused anoverstatement in the final results. The total producing department cost after all allocations is equal to $500,000 as indicated at the bottom of Exhibit 6-7.
Managerial Accounting
Each of these equations includes two unknowns, thus determining S1 and S2 requires solving the equations simultaneously. Although simultaneous equations are notnormally solved by hand in practice, one method is presented in Exhibit 6-6 to illustrate the concept. Observe that the denominator for the proportion of service provided from S1 to S2 is 900, not 950. This is because the 50 KWH’s of self service are ignored in thestep-down method.
1: Allocation of Service Department Costs
The two stage activity basedcosting approach is illustrated in Chapter 7 and focuses on eliminating the distortions that tend to occur when the traditional two stage approach is used. For example, if Product X consumes 30 percent of the power, 15 percent of the engineering workand 20 percent of the maintenance activity in Department A, then a single departmental overhead rate would distort product costs. This is because a singleactivity measure, or allocation basis can only represent one of these percentages. If the company uses machine hours as a basis, then power costsmight be accurately traced to Product X, but the product would be overcharged with engineering and maintenance costs.
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Conceptually, this is the same logical argument discussed inChapter 4 under the heading of reasons for using a predetermined overhead rate. First stage allocations may include self services and reciprocal services between service departments, as well as services to producing departments. Self service refers to situationswhere service departments use some of their own service. For example, the power department uses some power and the maintenance department requires somemaintenance.
A group of joint products is inseparable until the productsreach a certain point where they are divided or split into separate products. Producing more ofone product in the group means producing more of all products in the group. The key characteristic is that the products cannot be obtained separately. Forexample, the lumber products derived from a tree are joint products. The products obtained from a hog such as the chops, ham, and bacon are jointproducts. In fact, joint products are common in a variety of industries including petroleum, flour milling, meat packing, dairy, coal, copper, salt,chemicals, soap, gas, leather, and tobacco.
- A second method, frequently referred to as the traditional two stage allocation approach, recognizes that there are service areas and producing areas in the plant.
- Examples include top management salaries, internal auditing, company legal and medicalfacilities, advertising designed to promote the company image, public relations and landscaping around the facility.
- Forexample, the lumber products derived from a tree are joint products.
- Each method offers unique advantages and is suited to specific organizational structures and needs.
- Using the methods described in Chapter 3 (e.g., regression and correlation analysis) the system designer might attempt to definea relationship between the cost and the cost drivers objectively.
Since X1 consumed 9/10 of the machine time inthe Cutting department, (i.e., 3,960÷4,400) it seems logical that X1 should receive 90 percent of the overhead costs. Given advances in computing power, the reciprocal method would seem to be accessible to many companies that are not using it. Presumably, these companies believe that the benefits obtained from more accurate service department cost allocations do not justify the costs required to implement the reciprocal method. In fact, many companies do not allocate service department costs at all, either because they do not think these allocations are beneficial, or because they do not believe that the benefits justify the costs. The reciprocal method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations.
Using the “ability to bear”, or percentage of income perspective, gasoline taxesappear to be unfair to low income drivers. However, using the “benefits received” perspective, gasoline taxes appear to be fair. Reciprocal costs are how does the new tax law affect my health insurance a fundamental aspect of cost allocation in accounting and finance. For learners seeking to understand how costs are distributed across different departments or cost centers, grasping the concept of reciprocal costs is essential.
