Quiz 8: Cost Allocation: Practices

Business

The basic error that management is making in this case is allocating a joint cost, the grape costs, and then using these allocated numbers to assess product line profitability. Any decisions based on allocated joint costs are at risk of being wrong because the net realizable value (NRV) method for allocating grape costs is not being used.Tables 1 and 2 both contain grape costs allocated by gallons, not NRV. Therefore, these analyses do not measure the incremental contribution to cash flows if a product is dropped. If table wines are dropped, grape costs of $250,000 ($3.57/case) are not saved. The firm still is paying $1,900,000 for grapes. All that will happen is that the $250,000 that is being allocated to the table wines will now be absorbed by the remaining premium wines. Or, if this juice is sold to the bulk purchasers, then $100,000 ($250,000 - $150,000) will be absorbed by the premium wines. To assess the table wines' product line profitability, Exhibit A displays the incremental cash flows contributed by the table wines. img 1  This is the worst-case assumption in that all of the costs are assumed to be incurred to produce table wines. 2  General winery costs are not incremental with respect to table wines. Producing table wines generates incremental costs equal to the variable cost of the production facilities. From Exhibit A we see that the table wines are contributing positive cash flows. In fact, the cash flows of $267,425 exceed the amount by which the firm can sell the unprocessed juice ($150,000). The only question is whether these incremental cash flows (the $117,425 = 267,425 - 150,000) justify not selling the facilities. Exhibit B compares these two alternatives. img If we continue to produce, we forgo the $350,000, but we gain an additional $117,425 per year of cash flows. It would take a (real) before-tax cost of capital in excess of 30 percent to make the shutdown the better of the two decisions. Therefore, the best alternative is to keep producing. The president erroneously believes that he can save the grape costs if they shut down. Also, he believes that some of the fixed manufacturing overhead (in particular the winery costs) will be saved. But both of these are allocated costs. One way to avoid the misleading impression that the table wines are unprofitable is to allocate grape and common winery costs based on net realizable value (relative profitability) of the two products. This method does not distort the products' relative profitability. Exhibit C computes product profitability using net realizable value to allocate grape and manufacturing overhead costs. img 1 $390,380 = 91.1837% × $428,125 2 $37,745 = 8.8163% × $428,125, where $428,125 = $487,500-$59,375 and $59,373 = 25% × $237,500 since 25% of Production Facility costs are variable (see Table 2). Using net realizable value to allocate grape and manufacturing overhead costs produces a positive profit for the table wine product line. Notice that the total profits of premium and table wines of $692,500 is the same as that reported in Table 1 ($750,000 less loss of $57,500).

Step-down method: Under this method, first the management chooses a service department and allocates all its costs to the remaining service departments and operating divisions. Then it continues the process until all the service department costs are allocated.a) Effect of change in position for allocation: The sequence of the service department can affect the management's decision making, as the last service department in the sequence will have a higher unit cost of service. When the service department changes the sequence, the numerator increases by the costs of allocate service department and the other service departments are excluded from the denominator. What affects the allocated cost per meal? The cost gets affected basing on the method of allocation used. The allocation method affects the decisions of the departments to add or quit a product. Therefore, the method used for allocation plays a vital role in management decisions. b) Issues for considering moving the position in step down methodology: On inclusion of fixed costs, the total costs will not proportionately reduce on the fall of usage. Therefore, if the service department contains significant amounts of fixed costs, it will lead to significant problems. Result in cost per units may vary depending on different sequences. Moreover, the step-down method ignores the fact that the department which is allocated earlier may use the service departments which are later in the sequence.Therefore, the earlier departments are not allocated the costs of service departments in the later sequence though it uses the service department.

Net relative sales value method of apportioning the joint cost: Under this method, the total joint cost is divided by the total sales value of the products obtained from the process and then multiplied by their relative individual sales value of the product. On multiplication, the apportioned cost of the products will be obtained.a. Prepare the statement showing allocation of projected income of $420 million accounting income using physical volume method: img The result of the above excel is shown below: img Statement showing allocation of projected income of $420 million accounting income to the business of light distillates, processed heavy distillates and sold using net realizable value method: img The result of the above excel is shown below: img Prepare the statement showing ratio of accounting profits to net realizable value under both methods using the MS Excel sheet as shown below: img img The result of the above excel is shown below: img b. Prepare the statement showing projected accounting income if the crude oil is purchased from west T intermediate using the MS Excel sheet as shown below: img The result of the above excel is shown below: img Mr. Q has made the right decision to switch from West T intermediate to K Exports when the price differential between the two has reached $3.5. This is because the net accounting income of refinery is $360 million if raw crude oil is purchased from west T intermediate which is lower than the existed projected accounting profits of $420 million. The optimal decision rule of choosing west T or K export as a function of price differential is when the price differential between the two reaches $3 per barrel. If the difference between the price of light crude and heavy crude is less than $3 per barrel, then purchasing crude oil from west T is better. If the difference is exactly $3 per barrel, then the two options are indifferent. If the difference between the prices between the two increases from $3 per barrel, then purchasing crude oil from K export is preferable. Then calculate the break even differential rate using the equation as shown below. img Rearrange the above equation to find the value of P as shown below: img The break even differential is img . c. The decision would be different as against Mr. H. It would be profitable to expand the cracker capacity to 40 million barrels. This is because, after expanding the cracker capacity to 40 million barrels, the net realizable value of refinery will increase to $2,625 million as against existing net realizable value of $2,520 million. Prepare the statement showing calculation of net realizable value after expanding cat cracker capacity to 40 million barrels using the MS Excel sheet as shown below: img The result of the above excel is shown below: img d. If the price differential remains the same at $4 per barrel, then company should process heavy crude oil which is purchased from K exports. Processing heavy crude oil results heavy distillates in quantity more than the maximum capacity of cat cracker (that is 40 million barrels whereas maximum capacity of cat cracker is 30 million barrels). Thus, Mr. Q should expand the refinery's cat cracker capacity to 40 million barrels when the price differential between two crude oil is $4 per barrel. e. The expansion of cat cracker capacity should not be done. This is because the difference of price between west T intermediate and K export drops, there will be a negative NPV for the capital investment. The reason is, if the price differential drops, then light distillates from west T would be preferable and expansion of cat cracker capacity is not needed in this case.

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