7–3 What does the term reciprocal mean in the context of departmental cost allocation?
7-4 There are three methods for departmental cost allocation: the direct method, the
step method, and the reciprocal method.
The direct method of cost allocation is done by taking the service department
3. The allocation of costs of production departments to products
The first phase in departmental cost allocation has two parts: to trace the direct
manufacturing costs in the plant to each service and production department that used
7-6 There are a number of possible answers here. The chapter gives an example of
the use of departmental cost allocation in the banking industry. Other examples
would include cost allocation in an electric utility company to provide a basis for
3. The allocation of costs of production departments to products
The first phase in departmental cost allocation has two parts: to trace the direct
manufacturing costs in the plant to each service and production department that used
7-7 There are four methods for by-product costing:
The two asset recognition methods are:
Method 1 - Net Realizable Value Method. This method shows the net realizable
value of by-products in the income statement as a deduction from the total
manufacturing cost in the period in which the by-product is produced.
Method 2 - Other Income at Production Point Method. This method shows the
net realizable value of by-products in the income statement as an other income or
other sales revenue item in the period in which the by-product is produced.
The two revenue methods are:
Method 3 - Other Income at Selling Point Method. The net sales revenue from a
7–8 What are the limitations of joint product cost allocation?
7–9 What are the implementation issues of departmental cost allocation?
7–10 What are some of the ethical issues of cost allocation?
7-10 A number ethical issues are important when implementing cost allocation
methods. First, there are ethical issues when cost allocation is used in a situation
where the products or services are produced for both a competitive market and for
a public agency or government which is paying on a cost-plus basis. There is an
incentive for the provider to allocate an unfairly high portion of joint costs to the
cost-plus customer.
A second issue is the equity or “fair share” issue that arises when a government
reimburses costs of a private institution, or when government provides a service for
7-9 There are a number of implementation issues to consider when using either joint cost
allocation or departmental cost allocation.
One implementation issue is that it is often difficult to determine an appropriate
allocation base to allocate the joint product costs or to determine a figure for percentage
7-7 There are four methods for by-product costing:
The two asset recognition methods are:
Method 1 - Net Realizable Value Method. This method shows the net realizable
value of by-products in the income statement as a deduction from the total
manufacturing cost in the period in which the by-product is produced.
Method 2 - Other Income at Production Point Method. This method shows the
net realizable value of by-products in the income statement as an other income or
other sales revenue item in the period in which the by-product is produced.
The two revenue methods are:
Method 3 - Other Income at Selling Point Method. The net sales revenue from a
Brief Exercises 7-11 through 7-19
7-11 through 7-14 Involve departmental cost allocation with two service departments
and two production departments.
Percentage Service Provided to:
7-11 What is the amount of service department cost allocated to P1 and P2 using the
direct method?
7-12 What is the total cost in P1 and in P2 after allocation?
7-13
Total cost allocated to P1 is $17,500 and to P2 is $32,500
The Step Method
First Step
Service 1 Service % 30.00% 35.00% 35.00%
7-13 What is the amount of service department cost allocated to P1 and P2 using the step
method with S1 going first?
7-14 How does your answer to 12-11 change if the cost in Production 1 is changed from
$100,000 to $120,000?
7-11
Total cost allocated to P1 is $20,000 and to P2 is $30,000
The Direct Method
Service 1 Service % to producing departments 35.00% 35.00%
7-15, 16
Non Service
P1
P2
7-17,18
The cost allocations are shown below.
Sales Value: Units:
7-15 and 7-16 require the following information
Percentage Service Provided to:
7-15 What percentage of service department 1’s costs are allocated to P1 and to P2
under the direct method?
7-16 What percentage of service department 2’s costs are allocated to P1 and to P2
under the direct method?
7-17 through 7-20 require the following information about a joint production process
for three products, with a total joint production cost of $100,000. There are no
separable processing costs for any of the three products.
Sales Value Units at
7-17 What amount of joint cost is allocated to each of the three products using the
relative sales value method?
7-18 What amount of joint cost is allocated to each of the three products using the
physical units method?
7-17,18
The cost allocations are shown below.
Sales Value: Units:
7-19
First, the net realizable value of the by-product, $2,000 is reduced from the total joint
product cost; the by-product is inventoried at $2,000, and the remaining joint cost of
$98,000 is allocated to products 2 and 3 using the net realizable value method, as
follows:
7-19 Assume that the total sales value at the split-off point for product 1 is $50,000
instead of $130,000 and the sales value of product 3 is $2,000 instead of $20,000.
Assume also that, because of its relatively low sales value, the firm treats product 3 as
a by-product and uses the net realizable value method for accounting for joint costs.
What amount of joint cost would be allocated to the three products?
7-20 Assume the same as for 7-19 above except that product 3 is treated as a joint
product. What amount of joint costs would be allocated to the three products using
the relative sales value method?
Exercise 7-21 Cost Allocation, General
Solution (15 min)
An organization’s service and administrative costs can be substantial, and some or all of these costs usually are allocated
to cost objects. Thus, the allocations of service and administrative costs can have a significant impact on product cost and
pricing, asset valuation, and segment profitability.
Required
When service and departmental costs are allocated, they are grouped into cost pools and then allocated to cost
objects according to some allocation base.
a. Compare and contrast the benefit received and cause-and-effect criteria for selecting an allocation base.
b. Explain what the ability-to-bear costs criterion means in selecting an allocation base.
Cost pools are collections of costs that are similar in nature and have
a presumed causal connection. Examples of cost pools include
Exercise 7-22 By-Products and Decision-Making Strategy
Solution (15 min)
Lowman Gourmet Products produces a wide variety of gourmet coffees (sold in pounds of roasted beans), jams,
jellies, and condiments such as spicy mustard sauce. The firm has a reputation as a high-quality source of these
products. Lowman sells the products through a mail-order catalog that is revised twice a year. Joe, the president, is
interested in developing a new line of products to complement the coffees. The manufacture of the jams and jellies
presently produces an excess of fruit liquid that is not used in these products. The firm is now selling excess liquid to
other firms as flavoring for canned fruit products. Joe is planning to refine the liquid and add other ingredients to it to
produce a coffee-flavoring product instead of selling the liquid. He figures that the cost of producing the jams and
jellies, and therefore the fruit liquid, is irrelevant; the only relevant concern is the lost sales to the canneries and the
cost of the additional ingredients, processing, and packaging.
Required
How would you evaluate the financial and strategic issues facing Joe regarding the potential coffee-flavoring
product?
Joe is considering using a fruit-liquid, which is a by-product of the processing for his jams and jellies,
to produce a new product–a coffee flavoring to complement his line of gourmet coffees. Joe is correct
in understanding that the production cost of jams and jellies is irrelevant, since the fruit-liquid is a
necessary by-product of the production of jams and jellies. He is also correct to understand that the
cost of the additional ingredients and processing is relevant.
The correct financial decision is to compare the additional costs of the added ingredients and
processing, plus any additional packaging and handling costs for the new product versus the net
revenue from the sales to canneries–price to canneries less any selling costs. The key to the decision is
to ignore the joint costs, but focus instead only on the separable costs and the increase in sales value.
This question is addressed further in chapter 11 under the heading, “Decisions to Sell Before or After
Additional Processing.”
The more critical consideration is the strategic issue: will the new product line enhance the sales of
Exercise 7-23 Federal Reserve Banks; Cost Allocation
In recent years, due to the effects of the Great Recession on the construction industry, a decline in demand for paper
products, and increased demand for reduced carbon emissions from climate change, significant changes have taken
place in the harvesting and processing of wood products. The demand for lumber for construction has decreased, and
the demand for alternative fuels has increased. The result is that the timber industry in the southeastern states and some
1. Should the wood pellets be accounted for as a by-product or a main product for the timber industry? Explain briefly.
2. Assess the sustainability issue for the production of wood pellets. What are the advantages and disadvantages of the
use of wood pellets in power generation as a replacement for coal?
3. Most of the current demand for wood pellets if from EU countries. Would your answers above differ if the wood
pellets were used domestically instead of shipped to the EU for use there?
1. The wood pellets should be accounted for as a by-product since the
2. Some environmentalists have argued against the use of wood pellets
as a green source of energy. They say that it would take 54 years
for a new tree to consume the carbon emissions of a single tree
burned as pellets. Others argue that the use of timber for wood
3. The issues of sustainability and climate change are global issues.
That is, emissions anywhere in the world have an effect on climate
Exercise 7-24 Cost Allocation and Taxation at Nonprofit Organizations
Nonprofit organizations are exempt from federal income tax except for income from any activities that are unrelated to
the nonprofit’s charitable purpose. An example is the use of a laboratory for both tax-exempt basic medical research and
for testing a taxable product for commercial pharmaceutical firms. A concern in these cases is that the tax-exempt
nonprofit organization will be able to compete unfairly with for-profit firms because of their tax-exempt status. The key
argument is that common costs for the nonprofit’s exempt and business activities will be used to “subsidize” the for -profit
business (in this case, the taxable product testing).
Required
How would cost allocation play a role in affecting the profits of a nonprofit organization which has both business and
charitable activities?
Exercise 7-25 Fuel Surcharges; Allocating the Increased Cost of Fuel
U.S. Railroads, including Burlington Northern Santa Fe Corp (BNSF) and CSX Corp. began using fuel surcharges in 2001
to recapture some of the additional costs due to the sharp rise in fuel costs in late 1999, continuing into 2000. Fuel costs
have continued to increase and the fuel surcharges have continued to increase as well, accounting for approximately 12% of
BNSF’s revenues in the third quarter of 2008. Companies that use the railroads for shipping agricultural, chemical, and
other commodities have been critical of the allocation methods the railroads use to apply the surcharges. The railroads have
used surcharges based upon a percentage of charges for the shipment. Shippers have argued that an allocation based on
1. How would you propose that the increased cost of fuel be charged to shippers by the railroads?
2. Do you think the STB ruling should solve the problem?
3. What are the key sustainability issues for a consumer of rail transport?
1.,2.
The rising cost of fuel has affected many industries, but particularly
those in the transportation industries. In air freight, trucking, and
railroads, the surcharges can be as high as 35% of average charges.
The surcharges can be a substantial portion of total revenues for
these firms. The practice of fuel surcharges has grown widely to
include many service firms, involving most types of deliveries of
products or services (florists, retailers, appliance repair, and many
others). Unfortunately, many of these surcharges do not seem to be
reduced or removed when fuel prices fall.
The issue of surcharges for railroads has been a contentious
one for the shippers and railroads. There have been several law
suits regarding the conflicts and currently several of the largest U.S.
railroads are subject to a suit charging price fixing regarding their use
of surcharges. The railroads’ attempt to have the suit dismissed
recently failed in U.S. courts (https://ecf.dcd.uscourts.gov/cgi-
3. The sustainability issue arises in the case of rail transport because
rail transport is more efficient than truck transport. A shipper that
has the option between the two methods of transport should
consider the cost of shipping as well as the speed of delivery and
quality of service, in addition to the consideration of the
environmental impact of the greater use of fuel for the trucking
option.
Based on: “U.S. Appellate Court Reverses Class-certification
Decision for Fuel Surcharge-fixing Lawsuit Against Four Class Is,”
August 12, 2013,
http://www.progressiverailroading.com/norfolk_southern/news/US-
appellate-court-reverses-classcertification-decision-for-fuel-
surchargefixing-lawsuit-against-four-Class-Is--37234;
Also, Christine Hauser, “Shippers May Raise Fuel Fees,” The New
York Times, April 26, 2011; Mina Kimes, “Railroads: Cartel or Free
3. The sustainability issue arises in the case of rail transport because
rail transport is more efficient than truck transport. A shipper that
has the option between the two methods of transport should
consider the cost of shipping as well as the speed of delivery and
quality of service, in addition to the consideration of the
environmental impact of the greater use of fuel for the trucking
option.
Based on: “U.S. Appellate Court Reverses Class-certification
Decision for Fuel Surcharge-fixing Lawsuit Against Four Class Is,”
August 12, 2013,
http://www.progressiverailroading.com/norfolk_southern/news/US-
appellate-court-reverses-classcertification-decision-for-fuel-
surchargefixing-lawsuit-against-four-Class-Is--37234;
Also, Christine Hauser, “Shippers May Raise Fuel Fees,” The New
York Times, April 26, 2011; Mina Kimes, “Railroads: Cartel or Free
Problem 7-26 Cost Allocation and Legal Disputes
Cost allocation is often the centerpiece of conflict that is resolved in court cases. The litigation usually involves the dispute over
how costs are allocated to a product or product line that is of interest to the plaintiff. This is particularly an issue when a company
produces some products or services for a price-competitive market while other products or services are produced for a
governmental unit on a cost-plus or reimbursement basis.
The following cost allocation disputes involve an organization (Nursing Care Inc, or NCI) that operates both a nursing
home and an apartment building for retirees (retirement home). A single kitchen is used to provide meals to both the nursing
home and retirement home. Also, certain labor costs and utilities costs of the kitchen are shared by the two homes. Many of
those living in the nursing home are indigent and are on Medicaid. The state Department of Health and Family Services (DHFS)
reimburses NCI at Medicaid approved cost reimbursement rates. The Medicaid reimbursement rates are based on cost
information supplied by the organization, in this case NCI, and are assumed to be accurate; cost allocations are assumed to be
reasonable. DHFS has examined the cost report of NCI and has raised the following issues which are now being litigated.
Required
(the above is based upon an actual case, with names disguised)
For each issue, consider whether you think the defendant (NCI) or the plaintiff (DHFS) has the valid position, based on your
understanding of cost allocation.
a. DHFS alleges that NCI charged specific milk, condiments, and paper products to the nursing home, without following the
8-0986&invol=1
a. The court determined that further documentation was not required,
but that the stated reason for charging these items to the nursing
home is persuasive, and that further, DHFS had not shown that it had
asked NCI for the documentation. The specific assignment of these
costs to the nursing home was therefore allowed.
b. The court determined that DHFS had “no substantial basis” for
disallowing the direct assignment of the nourishment costs to the
nursing home. The court judged that it was apparent that the nursing
home residents were the exclusive consumers of these costs and that
the costs should therefore be traced directly to the nursing home.
The actual case is based on a dispute between the Department of Health
8-0986&invol=1
a. The court determined that further documentation was not required,
but that the stated reason for charging these items to the nursing
home is persuasive, and that further, DHFS had not shown that it had
asked NCI for the documentation. The specific assignment of these
costs to the nursing home was therefore allowed.
b. The court determined that DHFS had “no substantial basis” for
disallowing the direct assignment of the nourishment costs to the
nursing home. The court judged that it was apparent that the nursing
home residents were the exclusive consumers of these costs and that
the costs should therefore be traced directly to the nursing home.
Problem 7-27 Cost Allocation; Cost Shifting
In the last several years, airlines have succeeded in boosting profits by adding fees for previously free services such as in-flight
snacks and meals, checked baggage, priority boarding, and other services. These fees have caused some shifts in customer
1. The cost-shifting in this case is from the airlines (that experience
lower costs of baggage handling) to TSA (that experience a larger
number of “carry-on” bags to examine) and to the airline passengers
(who experience the discomfort of increased time in going through
TSA security and the cost of the $2.50 security fee that is included in
2. Cost-shifting is frequently an area of ethical concern, as it involves
3. Given the emphasis airline customers place on price, air travel has
become somewhat of a commodity. It is hard to differentiate the
different carriers. The “fees for services” approach is consistent with
From: To:
1) The Direct Method
Net service to both Production Departments
(Advertising and Sales) for the Actuarial Service Dept:
20%
Advertising Department Share: 50%
Sales Department Share: 50%
Net service to both Production Departments
for Premium Department: 80%
Advertising Department Share: 25%
Exercise 7-28 Departmental Cost Allocation
HomeLife Life Insurance Company has two service departments (actuarial and premium rating) and two production
departments (advertising and sales). The distribution of each service department’s efforts (in percentages) to the other
departments is as follows:
2) The Step Method
The Actuarial Department goes first since it provides the greatest service to the other service
departments:
Actuarial Department
3) The Reciprocal Method
Solve the Simultaneous Equations: (S1=Actuarial; S2=Premium)
S1 = $80,000 + .2 x S2
S2 = $15,000 + .8 x S1
S1 = $80,000 + .2 x ($15,000 + .8 x S1)
S1 = $98,810
S2 = $15,000 + .8 x $98,810
S2 = $94,048
Advertising
Sales
Sales
Department
Department
Department
Premium
Advertising
S1 - 10% 20% ? %
S2 10% - ? % 30%
Exercise 7-29 Departmental Cost Allocation
3. Determine the total cost of P1 and P2 using the reciprocal method.
1) The Direct Method
Net service to both Production Departments
for Service Department 1: 90%
Production Department 1's Share: 22%
Production Department 2's Share: 78%
Net service to both Production Departments
for Service Department 2: 90%
Production Department 1's Share: 66.67%
Production Department 2's Share: 33.33%
2) The Step Method
Both service departments serve each other the same percentage of
total service; hence, either can go first. Here, Service Department 1 goes
first on the basis that it has the higher total cost:
Service Department 1
Production
Department 2
Department 2
Department 1
Service
Production
3) The Reciprocal Method
Solve the Simultaneous Equations:
S1 =
$180,000 + .1 x S2
S2 = $60,000 + .1 x S1
S1 = $180,000 + .1 x ($60,000 + .1 x S1)
S1 = $187,879
S2 = $60,000 + .1 x $187,879
S2 = $78,788
Solution (15 min)
Exercise 7-30 Joint Products; Blood Donation
3. Plasma, used after further processing, for the treatment of protein deficiency.
The joint cost of producing the three products consists of the blood collection costs, the safety testing costs, and further
processing in a laboratory to split off the three joint products. Commonly the joint costs are allocated to the three products on the
basis of physical
units produced. The National Blood Authority (NBA) in the U.K. observed the unfavorable effect of this approach is that the cost
of each blood product could change significantly from time to time, as the demand for the products varied; the demand for the
platelets was particularly volatile. In response, the NBA decided in to allocate all joint costs to red cells, on the basis, in part, that
plasma was routinely discarded to minimize the risk of Creutzfeld-Jacobs disease.
Required: What are the advantages and disadvantages of the allocation approach proposed by the NBA? What allocation
method would you suggest as an alternative, if any?
As the text notes, the physical units method often involves inappropriate allocation of costs as the physical
Units Produced
Product and Sold Total Additional Costs Total Sales Value
M 10,000 $10,000 $160,000
N 4,000 $10,000 $140,000
T 5,000 $5,000 $25,000
Exercise 7-31 Joint Products
After Split-Off
Solution (10 min)
Tango Company produces joint products, M, N, and T from a process. The following information concerns a batch
produced in April at a cost of $120,000:
Required
How much of the joint cost should be allocated to each joint product using the net realizable value method.
The allocation for the net realizable value method is shown below. Note
however, that Product B has a very small sales value relative to the two
other products. Should it more properly have been treated as a by-
product?
Outputs (gallons):
Product A = 5000
Product B = 1,000
Joint Costs = $5,600
Sales value at Split-off Point:
Product A = $2.00
Product B = $30.00
Separable costs per unit:
Product B = $2.50
Exercise 7-32 Joint Products
Arkansas Corporation manufactures liquid chemicals A and B from a joint process. It allocates joint costs on the
basis of sales value at split-off. Processing 5,000 gallons of product A and 1,000 gallons of product B to the split-off
point costs $5,600. The sales value at split-off is $2 per gallon for product A and $30 for product B. Product B
requires additional processing beyond the split-off point, at a cost of $2.50 per gallon, before it can be sold.
Required
What is the company’s cost to product 1,000 gallons of product B?
Output Volume:
A = 25,000
B = 20,000
C = 10,000
Exercise 7-33 Joint Products and By-Product Costing (Appendix)
Webster Company produces 25,000 units of A, 20,000 units of B, and 10,000 units of product C from the same
manufacturing process at a cost of $340,000. A and B are joint products, and C is regarded as a by-product. The unit
selling process of the products are $30 for A, $25 for B, and $1 for C. None of the products require additional
processing. Of the units produced, Webster Company sells 18,000 units of A, 19,000 units of B, and 10,000 units of
C. The company uses the net realizable value (NRV) method to allocate joint costs and by-product costs. Assume no
beginning inventory.
1. What is the value of the ending inventory of product A?
2. What is the value of the ending inventory of product B?
Problem 7-34 Departmental Cost Allocation; Outsourcing
Marin Company produces two software products (Cloud-X and Cloud-Y) in two separate departments (A and B).
These products are highly regarded network-maintenance programs. Cloud-X is used for small networks and Cloud-Y
is used for large networks. Williams is known for the quality of its products and its ability to meet dates promised for
software upgrades.
Department A produces Cloud-X and Department B produces Cloud-Y. The production departments are supported by
two support departments, systems design and programming services. The source and use of the support department
time are summarized below:
2. The company is considering outsourcing programming services to DDB Services, Inc., for $25.00 per hour. Should
Tanner do this?
Second Step
Sourcing
Operations Assembly Finishing
Problem 7-35 Departmental Cost Allocation; Outsourcing
Total Labor Hours Used by Dpeartments
Logan Products has two production departments – assembly and finishing. These are supported by two service
departments – sourcing (purchasing and handling of raw materials and human resources) and operations (work
scheduling, supervision, and inspection). Logan has the following labor hours devoted by each of the service departments
to the other departments:
2. What are the total costs in the production departments after allocation?
percent 8.33% 0.00% 50.00% 41.67% 100%
1. Revised cost allocation:
Production Dept.
A 115,000$ 25% 112,500$
Allocation of Total
Maintenance Cost
Outside Price
Percentage based on
Outside Price
Problem 7-36 Departmental Cost Allocation; Outsourcing
McKeoun Enterprises is a large machine tool company now experiencing alarming increases in maintenance expense in
each of its four production departments. Maintenance costs are currently allocated to the production departments on the
basis of labor-hours incurred in the production department. To provide pressure for the production departments to use
less maintenance, and to provide an incentive for the maintenance department to become more efficient, McKeoun has
decided to investigate new methods of allocating maintenance costs. One suggestion now being evaluated is a form of
outsourcing: The producing departments could purchase maintenance service from an outside supplier. That is, they
2. If McKeoun follows the proposed plan, what is likely to happen to the overall use of maintenance? How will each
department managers be motivated to increase or decrease the use of maintenance? What will be the overall
effects of going to the new plan?
2. The overall effect of the new plan will be to motivate the production
departments to continue to use the internal supplier of maintenance
when the outside price is high (as in Departments A and C), and
motivate those departments which have an opportunity to obtain
1,250,000 1,750,000
210,000 600,000
Percentage of estimated dollars of work and time by CFL:
10% service to the computer group
15% service to market research
75% service to financial analysis
Percentage of estimated dollars of work and time by the computer group:
CFL Group
15.00% 75.00%
Allocation % per the direct method 16.7% 83.3%
Allocation amount (210,000)$ 35,000$ 175,000$
Computer Service % to producing departments 40.00% 40.00%
Allocation % per the direct method 50.0000% 50.0000%
Allocation amount (600,000)$ 300,000 300,000
Totals for Production Departments 1,585,000$ 2,225,000$ 3,810,000$
Step Method
CFL Group Computer Mkt Resrch Finan Analysis Total
DEPARTMENTAL ALLOCATION BASES
CFL Group - - -
percent 10.00% 15.00% 75.00% 100%
Computer - - - - -
percent 20.00% 0.00% 40.00% 40.00% 100%
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Support Departments
Producing Departments
Problem 7-37 Departmental Cost Allocation
Barfield Corporation prepares business plans and marketing analysis for start-up companies in the Cleveland area.
Barfield has been very successful in recent years in providing effective service to a growing number of clients. The
company provides its service from a single office building in Cleveland, and is organized into two main client-service
groups: one for market research and the other for financial analysis. The two groups are treated as cost centers with
budgeted annual costs of $1,250,000 and $1,750,000, respectively. In addition, Barfield has a support staff that is
organized into two main functions; one for clerical, facilities, and logistical support (called the CFL group) and another
for computer-related support. The CFL group is also a cost center with budgeted annual costs of $210,000, while the
annual cost of the computer group is $600,000.
Tom Miggs, CFO of Barfield, plans to prepare a departmental cost allocation for his four groups, and he assembles the
following information:
Totals for All Departments $210,000 $600,000 $1,250,000 $1,750,000 $3,810,000
SECOND PHASE: Reallocate Service Department Costs to Production Departments:
The Step Method
First Step
Design Service % 10.00% 15.00% 75.00%
Amount (210,000) $21,000 $31,500 $157,500
Second Step
Programming Service % 40.00% 40.00%
Allocation percent per service share % 50.0000% 50.0000%
Amount ($621,000) 310,500 310,500
Totals for Production Departments $1,592,000 $2,218,000 $3,810,000
Maintenance Utilities
Overhead cost incurred $115,000
$65,000
Service provided to departments
Problem 7-38 Departmental Cost Allocation
Service departments
Solexx Corporation distributes its service department overhead costs to product departments. This information is for the
month of June:
(1) the direct method, (2) the step method, and (3) the reciprocal allocation method?
Totals for Production Departments $72,868 $107,132 $180,000
Info Systems
Service % to producing departments
40.0000% 10.0000% 30.0000%
Allocation % per the direct method 50.0000% 12.5000% 37.5000%
Allocation amount ($80,000) $40,000 $10,000 $30,000
Facilities Service % to producing departments 40.00% 25.00% 25.00%
Allocation % per the direct method 44.4444% 27.7778% 27.7778%
Allocation amount ($40,000) $17,778 $11,111 $11,111
Totals for Production Departments $217,778 $211,111 $166,111 $595,000
Step Method: Information Systems Goes First
Info Systems Facilities Programming Consulting Training Total
Problem 7-39 Departmental Cost Allocation
Support Departments
Producing Departments
Computer Intelligence, a computer software consulting company, has three major functional areas: computer programming,
information systems consulting, and software training. Carol Bingham, a pricing analyst in the accounting department, has been
asked to develop total costs for the functional areas. These costs will be used as a guide in pricing a new contract. In computing
these costs, Carol is considering three different methods of the departmental allocation approach to allocate overhead costs: the
1. Using as the application base computer usage time for the information systems department and square feet of floor space for
2. Rather than allocate costs, how might Computer Intelligence bet ter assign the information systems department’s costs?
First Step 20.0000% 40.0000% 10.0000% 30.0000%
Allocation percent per direct method
44.4444% 27.7778% 27.7778%
Amount ($56,000) $24,889 $15,556 $15,556
Totals for Production Departments $216,889 $213,556 $164,556 $595,000
Step Method: Facilities Goes First
Info Systems Facilities Programming Consulting Training Total
DEPARTMENTAL ALLOCATION BASES
Info Systems 600 1,200 300 900 3,000
percent 20.00% 40.00% 10.00% 30.00% 100.00%
Facilities 240 960 600 600 2,400
percent 10.00% 40.00% 25.00% 25.00% 100.00%
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Totals for All Departments $80,000 $40,000 $160,000 $190,000 $125,000 $595,000
SECOND PHASE: Reallocate Service Department Costs to Production Departments:
The Step Method
First Step
Facilities Service % 10% 40.00% 25.00% 25.00% 100%
Amount $4,000 ($40,000) $16,000 $10,000 $10,000
Second Step
Info Systems Service % 40.0000% 10.0000% 30.0000%
Allocation per service share % 50.0000% 12.5000% 37.5000% 100%
Amount ($84,000) $42,000 $10,500 $31,500
Totals for Production Departments $218,000 $210,500 $166,500 $595,000
Support Departments
Producing Departments
Direct Cost
Information technology $6,000
Administration $122,000
Education $100,000
Program management $190,000
$418,000
Indirect Costs:
Allocated on basis of DLHs = $50,000
Allocated on basis of headcount = $15,000
Mental health
Housing
Labor-hours in education
Headcount in program management
DIRECT METHOD
Base IT Admin Education Program Mgt Mental Health Housing
Total
DEPARTMENTAL ALLOCATION BASES
Direct Labor Hr DLH 2,000 6,000 4,000 4,000 16,000
percent 12.5% 37.5% 25.0% 25.0% 100%
Headcount HCT 2 3 3 4 12
percent 16.7% 25.0% 25.0% 33.3% 100.0%
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Direct Costs 6,000$ 122,000$ 100,000$ 190,000$ 418,000$
Indirect Costs:
Labor DLH 6,250 18,750 12,500 12,500 50,000$
Supplies HCT 2,500 3,750 3,750 5,000 15,000$
Totals for All Departments 14,750$ 144,500$ 116,250$ 207,500$ 483,000$
SECOND PHASE: Reallocate Service Department Costs to Education and Program Mgt Departments:
The Direct Method
IT Service % to producing departments 20% 60%
Allocation % per the direct method 25.0% 75.0%
Allocation amount (14,750)$ 3,688$ 11,063$
Admin Service % to producing departments 30% 60%
Allocation % per the direct method 33.3333% 66.6667%
Allocation amount (144,500)$ 48,167 96,333
Totals for Production Departments 168,104$ 314,896$ 483,000$
THIRD PHASE: Allocate Main Department Costs to Programs
Base: Direct Labor Hours for each product 2,000 2,000 4,000
percent 50% 50%
Headcount 1 3 4
percent 25% 75%
Programs
Solution (35 min)
Problem 7-40 Departmental Cost Allocation; Not-for-Profit
Labor Hours
No. of Personnel
2,000
2
6,000
3
4,000
4
3
4,000
Departments
Service
Main
4
Headcount
2,000
1
2,000
Labor Hours
4,000
3
The Fleming Foundation is a charitable organization founded by Gaylord Fleming and Sandy Fleming. The Flemings
intended for the charity to provide programs in health care for the elderly, particularly those in poverty. The two main
program divisions of the foundation are mental health for the elderly and housing for the elderly. In addition to these
programs, the Foundation also provides health care educational programs and has a significant fund-raising effort to help the
Foundation to grow and to accomplish the goals of the founders. The foundation is organized into two main departments –
education and program management. These departments are supported by two service departments – information technology
(IT) and administration.
There are $418,000 of costs directly traceable to each of the four departments. An additional $65,000 of indirect costs
are shared among the four departments - $50,000 of which is allocated to the departments based on direct labor-hours and
$15,000 to the departments based on the number of personnel (headcount) in the departments.
The cost, labor-hours, and headcount in these departments in the most recent year are as follows:
The costs of the two main departments (Education and Program Management) are allocated to the two programs (Mental
Health and Housting) as follows: the costs in education are allocated on the basis of labor-hours in the programs, while the
costs in program management are allocated using the headcount used in the two programs. The following table shows the
labor hours and headcount consumption by the two programs.
Required
Determine the costs allocated to the mental health and housing programs using the direct method, the step method (assuming
that IT goes first), and the reciprocal method.
Labor DLHs 6,250 18,750 12,500 12,500 50,000$
Info. Tech Operations Claims Proc. Administration Sales
Information Technology 20% 20% 40% 20%
Facilities 10% 10% 50% 30%
The total costs incurred in the five departments are:
Information Technologies 600,000$
Facilities 1,800,000
0.3
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Totals for All Departments 600,000$ 1,800,000$ 450,000$ 850,000$ 650,000$ 4,350,000$
SECOND PHASE: Reallocate Service Department Costs to Operating Departments:
The Direct Method
Info Tech Service % to producing departments 20.00% 40.00% 20.00% 80%
Allocation % per the direct method 30/70=42.86%;20/70=28.57 25.0000% 50.0000% 25.0000%
Allocation amount (600,000)$ 150,000$ 300,000$ 150,000$
Operations Service % to producing departments 10.00% 50.00% 30.00% 90%
Allocation by service share % 20/90=22.22%;40/90=44.44%;30/90=33.33% 11.1111% 55.5556% 33.3333%
Allocation amount (1,800,000)$ 200,000 1,000,000 600,000
Totals for Operating Departments 800,000$ 2,150,000$ 1,400,000$ 4,350,000$
The Step Method (Info Tech First)
Info Technology Operations Claims Process Operations Sales
Total
DEPARTMENTAL ALLOCATION BASES
Info Technology percent 20.00% 20.00% 40.00% 20.00% 100%
Operations percent 10.00% 0.00% 10.00% 50.00% 30.00% 100%
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Totals for All Departments 600,000$ 1,800,000$ 450,000$ 850,000$ 650,000$ 4,350,000$
SECOND PHASE: Reallocate Service Department Costs to Operating Departments:
The Step Method
Info Technology Service % to producing departments 20% 20% 40% 20% 100%
Allocation amount (600,000)$ 120,000$ 120,000$ 240,000$ 120,000$
Operating Departments
Support Departments
Problem 7-41 Departmental Cost Allocation; Insurance Company
Support Departments
Operating Departments
Comprehensive Insurance Company has two service lines, health insurance and auto insurance. The two product lines are served
by three operating departments which are necessary for providing the two types of services: claims processing, administration, and
sales. These three operating departments are supported by two departments: information technology and operations. The support
provided by information technology and operations to the other departments is shown below.
The Step Method
0.3
FIRST PHASE: Trace Direct Costs and Perform Initial Allocation of Indirect Costs
Totals for All Departments 600,000$ 1,800,000$ 450,000$ 850,000$ 650,000$ 4,350,000$
SECOND PHASE: Reallocate Service Department Costs to Operating Departments:
First: Solve the simultaneous equations for service 1 and service 2
Amount allocated from info systems
795,918.37
Amount allocated from facilities
1,959,183.67
Second: Allocate to Producing Departments
Smooth Skin =
$2.40 per gallon
Silken Skin = $3.90 per gallon
Problem 7-42 Joint Product Costing
Choi Company manufactures two skin care lotions, Smooth Skin and Silken Skin, from a joint process. The joint
costs incurred are $420,000 for a standard production run that generates 180,000 gallons of Smooth Skin and 120,000
gallons of Silken Skin. Smooth Skin sells for $2.40 per gallon, while Silken Skin sells for $3.90 per gallon.
1. Assuming that both products are sold at the split-off point, how much of the joint cost of each production run is
allocated to Smooth Skin on the sales value basis?
2. If not additional costs are incurred after the split-off point, how much of the joint cost of each production run is
allocated to Silken Skin on the physical measure method basis?
3. If additional processing costs beyond the split-off point are $1.40 per gallon for Smooth Skin and $0.90 per gallon for
Silken Skin, how much of the joint cost of each production run is allocated to Silken Skin on a net realizable value
basis?
4. If additional processing costs beyond the split-off point are $1.40 per gallon for Smooth Skin and $0.90 per gallon for
Silken Skin, how much of the join cost of each production run is allocated to Smooth Skin on a physical measure
method basis?
Allocated Joint Cost $252,000 $168,000 $420,000
Data for analysis:
Joint costs, standard production run = $450,000
Output (units), standard production run:
MSB = 80,000
Problem 7-43 Joint Product Costing
Northwest Building Products (NBP) manufactures two lumber products from a joint milling process: residential
building lumber (RBL) and commercial building lumber (CB) A standard production run incurs joint costs of
$450,000 and results in 80,000 units of RBL and 120,000 units of CB. Each RBL sells for $10.00 per unit and each
CB sells for $12.00 per unit.
1. Assuming that no further processing occurs after the split-off point, how much of the joint costs are allocated to
commercial lumber (CB) on a physical measure method basis?
2. If not further processing occurs after the split-off point, how much of the joint cost is allocated to the mine support
braces (RBL) on a sales value basis?
3. Assume that the CB is not marketable at split-off but must be planed and sized at a cost of $300,000 per production
run. During the process, 10,000 units are unavoidably lost and have no value. The remaining units of CBL are
salable at $14 per unit. The RBL, although salable immediately at the split-off point, are coated with a tarlike
preservative that costs $200,000 per production run. The braces are then sold for $12 each. Using the net realizable
value basis, how much of the completed cost should be assigned to each unit of CBL?
4. Should NBP choose to process the RBL beyond split-off? What would be the contribution if it did so?
Sales Value Method RBL CB Total
Problem 7-44 Joint Products
The Salinas Company produces three products, X, Y, and Z, from a joint process. Each product can be sold at the split-
off point or processed further. Additional processing requires no special facilities, and the production costs of further
processing are entirely variable and traceable to the products involved. Last year all three products were processed
3. Should the firm sell any of its products after further processing?
4. Salinas has been selling all of its products at the split-off point. Selling any of the products after further processing
will entail direct competition with some major customers. What strategic factors does the firm need to consider in
deciding whether to process any of the products futher?
Unit Gross Profit $1.6000 $0.8167 -$1.4000
A101 A204 B216 Total
Units Sold 175,000 135,000 115,000 425,000
Price (after addt'l processing) 14.00$ 10.00$ 12.00$
Separable Processing cost 550,000 125,000 625,000 1,300,000$
Units Produced 175,000 135,000 115,000 425,000
Total Joint Cost 3,500,000
Sales Price at Split-off 10.00 5.00 10.00
Sales Value (after addt'l processing) 2,450,000 1,350,000 1,380,000 5,180,000
Sales Value at Split Off 1,750,000 675,000 1,150,000 3,575,000
(a) Physical Unit Method
A101 A204 B216 Total
Units of Production 175,000 135,000 115,000 425,000
Percent of Total 41.18% 31.76% 27.06% 100%
Joint Cost Allocation 1,441,176$ 1,111,765$ 947,059$ 3,500,000$
Separable Processing cost 550,000 125,000 625,000 1,300,000
Total Cost 1,991,176$ 1,236,765$ 1,572,059$ 4,800,000$
Total Cost per unit 11.3782$ 9.1612$ 13.6701$
Calculation of Gross Margin
Sales 2,450,000$ 1,350,000$ 1,380,000$ 5,180,000$
Cost of Goods Sold
Allocated Joint Cost 1,441,176 1,111,765 947,059 3,500,000$
Separable Costs 550,000 125,000 625,000 1,300,000$
Total Cost 1,991,176$ 1,236,765$ 1,572,059$ 4,800,000$
Gross Margin 458,824$ 113,235$ (192,059)$ 380,000$
Sales Value at Split Off Method - Data A101 A204 B216 Total
Units Sold 175,000 135,000 115,000 425,000
Price (after addt'l processing) 14.00$ 10.00$ 12.00$
Separable Processing cost 550,000$ 125,000$ 625,000$ 1,300,000$
Units Produced 175,000 135,000 115,000 425,000
Total Joint Cost 3,500,000$
Sales Price at Split-off 10 510
Sales Value (after addt'l processing) 2,450,000$ 1,350,000$ 1,380,000$ 5,180,000$
Problem 7-45 Joint Products
Solution (20 min)
Johnston Adhesives Company makes three widely used industrial adhesives: A101, A204, and B216. See sales and production
information for a gallon of each of the three adhesives in the following table. Most of Johnston’s customers ask for a special
blend of the three products which improves heat resistance. The additional processing requires additional time and materials,
and the price is increased accordingly, as shown in the table. Assume that Johnston produces only for specific customer orders,
2. Which of the four methods do you think would be preferred in this case? Why?
Sales Value at Split Off 1,750,000$ 675,000$ 1,150,000$ 3,575,000$
(b) Sales Value at Split-Off Method
A101 A204 B216 Total
Sales Value at Split Off 1,750,000$ 675,000$ 1,150,000$ 3,575,000$
Percent of Total 48.9510% 18.8811% 32.1678% 100%
Joint Cost Allocation 1,713,287$ 660,839$ 1,125,874$ 3,500,000$
Separable Processing cost 550,000$ 125,000$ 625,000$ 1,300,000$
Total Cost 2,263,287$ 785,839$ 1,750,874$ 4,800,000$
Total Cost per unit 12.933$ 5.821$ 15.225$
Calculation of Gross Margin
Sales 2,450,000$ 1,350,000$ 1,380,000$ 5,180,000$
Cost of Goods Sold
Allocated Joint Cost 1,713,287 660,839 1,125,874 3,500,000$
Separable Costs 550,000 125,000 625,000 1,300,000$
Total Cost 2,263,287 785,839 1,750,874 4,800,000$
Gross Margin 186,713$ 564,161$ (370,874)$ 380,000$
A101 A204 B216 Total
2. In this case the net realizable value method should be preferred because
all Johnston’s production is processed further, and the NRV method
Problem 7-46 Joint Products; By-Products (Appendix)
Multiproduct Corporation is a chemical manufacturer that produces two main products (Pepco-1 and Repke-3) and a by-
product (SE-5) from a joint process. If Multiproduct had the proper facilities, it could process SE-5 further into a main
product. The ratio of output quantities to input quantity of direct material used in the joint process remains consistent with
the processing conditions and activity level. Multiproduct currently uses the physical measure method of allocating joint
costs to the main products. It uses the first-in, first-out (FIF) inventory method to value the main products. The by-product is
inventoried at its net realizable value, which is used to reduce the joint production costs before they are allocated to the main
products. Jim Simpson, Multiproduct’s controller, wants to implement the sales value method of joint cost allocation. He
believes that inventory costs should be based on each product’s ability to contribute to the recovery of joint production costs.
The net realizable value of the by-product would be treated in the same manner that the physical method would. Data
1. The relative sales value method of joint cost allocation assigns cost in
proportion to each product's sales value to the sales value of all products.
If there is no sales value at split-off, then the value at the first sales point
less separable costs is used. If joint products have a sales value at the
split-off point, the margin for all joint products at the split-off point will be
2. a. Because both main products have a market value at the split-off
point, this value is used to allocate the joint cost rather than the final sales
value.
Joint production costs to be allocated $2,640,000
Less net realizable value of by product $120,000
Joint costs to be allocated $2,520,000
SE-5 $120,000
November joint production costs $2,640,000
Pepco-1 Repke-3 SE-5
S-210 H-35 J-23
July sales in gallons 600,000 225,000 20,000
July production in gallons 660,000 225,000 30,000
S-210 H-35 J-23 Total
Units Sold 600,000 225,000 20,000 845,000
Units Produced 660,000 225,000 30,000 915,000
Final Sales Price 5.85$ 6.25$ 0.70$
Sales Value of By-Product 21,000$
Final Sales Value of Joint Products 3,861,000$ 1,406,250$ 5,267,250$
Additional Processing Costs 1,233,000 525,000 - 1,758,000
Net Realizable Value (NRV) 2,628,000$ 881,250$ 3,509,250$
Problem 7-47 Joint Products
Quality Chemicals manufactures three chemicals for industrial and retail customers. The largest volume product, S-210, is a
sweetener used in the preparation of processed foods. The second, H-35, is used in the manufacture of commercial and
3. As a production supervisor for Quality Chemical, you have learned that small quantities of the critical chemical
compound in H-35 might be present in S-210. What should you do?
1. Because by-products are assigned an inventory cost equal to their net
Summary of Recent Month's Activity Ying Yang Bit
Units Sold 50,000 40,000 10,000
Units Produced 50,000 40,000 10,000
Additional Processing Costs - Variable 140,000$ 42,000$ -$
Additional Processing Costs - Fixed 10,000$ 8,000$ -$
Sales Price 6.00$ 12.50$ 1.60$
Total Joint Cost 265,000$ ($115,000 variable)
By-Product
Ying Yang Bit Total
Units Sold 50,000 40,000 10,000 100,000
Units Produced 50,000 40,000 10,000 100,000
Separable Processing Costs - Variable 140,000$ 42,000$ -$ 182,000$
Separable Processing Costs - Fixed 10,000 8,000 - 18,000
Problem 7-48 Joint Products; By-Products (Appendix)
Solution (40 min)
Joint Products
2. Calculate the gross margin for each product
Problem 7-49 Joint Products
Yonica Petroleum is a global manufacturer of specialty chemicals which are made from the waste products of the petroleum
industry. Yonica in effect recycles a good portion of the waste from the refineries used by the large oil companies. The specialty
chemicals are used as cleaning solvents and lubricants in industrial applications. Yonica has three products -- Y64, G22 and X17
1. Calculate the product cost of each of the three product lines using the following methods:
2. Which of the three methods do you think would be preferred in this case? Why?
3. While Yonica chose to process all three products beyond the split-off point, do you think this is the correct
decision? Which products, if any, do you think should have been processed beyond the split-off point, and
4. Since Yonica is involved in the recycling of waste chemicals, it is able to purchase its raw materials at
greatly reduced cost. However, its manufacturing costs are slightly higher than some of its competitors
5. What are some of the global issues that Yonica should consider in effectively executing its strategy?
6. What should Yonica do, if anything, to improve the overall effect of its operations on the environment?
Separable Costs 65,500 34,250 55,400 155,150$
3. The increase in sales value after additional processing cost is greater
than the additional processing costs for all three products, so that
Yonica has the correct policy in processing all products to the final
3. The increase in sales value after additional processing cost is greater
than the additional processing costs for all three products, so that
Yonica has the correct policy in processing all products to the final
4. Yonica’s strategy is based on environmentally friendly policies, and
the odds are that the company’s customers will increasingly seek out
companies, like Yonica, that produce environmentally friendly
5. The key global issues for Yonica include the strategic decisions
6. Yonica has a good position in sustainability because the company’s
Problem 7-50 Joint Cost Allocation: Managerial Incentives
Cameron Manufacturing produces auto parts for auto manufacturers and parts wholesalers. The business is very competitive, and
productivity measures are used throughout its eight manufacturing plants. Jill Owens, the manufacturing vice president, explains to
her plant managers the importance of reducing cycle time, improving throughput, and reducing waste. One type of waste she keeps
close track of is that due to accidents and injuries on the job. Jill believes that a safe work place also contributes to productivity. A
reduction in accidents and injuries can also lead to a reduction in the insurance the firm pays to cover its liability in these incidents.
The premium for this insurance coverage is a single policy and is a joint cost shared by all eight plants. One of the plant managers,
Mike Griffin, notes that the current procedure for allocating the cost of insurance, which is based on the total plant output, does not
provide plant managers with the desired incentive to reduce accidents. It just means that the larger plants get charged more. Mike
suggests that the insurance cost should be charged to the plants based on the number of manufacturing personnel in each plant.
Required
What do you think of Mike’s suggestion? What alternative would you suggest, if any, for allocating the cost of insurance to the
plants?