Quiz 11: Service Department and Joint Cost Allocation

Business

Cost accounting system This is a system designed for inhouse or internal managers and their decision making. Cost accounting information is not needed for comparison with other companies. This information is commonly used in financial accounting also, but it is primarily used by company managers for their decision making. It is important that cost accounting information is relevant for the decision making of the manager. Cost allocation It is easy to calculate the cost of product if components of the products are directly used and not shared like direct labor is not shared resource. It becomes difficult to allocated the cost of common resources like depreciation on machine or rent of warehouse building which is used for two products manufacturing. Role of cost allocation comes into play when common cost needs to allocated to two or more products or departments. There different basis used for cost allocation like number units used, labors hours, area used by departments or products etc. Cost allocation base must be the one that best establishes the connection between the overhead incurred and the activity. Cause and effect basis can be effective way to identify cost allocation base. Advantages and disadvantages of cost allocation Advantages of cost allocation may be summarized as under: - •It helps in correct cot determination of products or services •It also helps in pricing products where profit margins are safely added to costs. •It helps to identify the product or department is cost is incurred high and cost may be managed by focusing on that. •It supports in department performance evaluation and profitability assessment etc. Disadvantages of cost allocation may be summarized as under: - •It may result in wrong cost allocation which might inflate the cost unnecessarily •It is difficult to have correct cost driver available for all overheads cost allocation which may disturb the product costing. •Success of cost allocation depends a lot on honesty and accuracy of individuals performing cost allocations •It is time consuming and costly exercise which may outweigh its benefits in certain situations etc.

In all the methods of allocation of cost, direct method, step method and the reciprocal method, service cost is allocated to production departments on the basis of related allocation basis. In the direct method of allocation the service department cost is allocated directly to the related production department which has used the service. In the step method the allocation of cost of service departments are allocated to other service departments and if the service is used by the production department the cost is directly allocated to that production department. Once the allocation of cost of service department is made then no service department will reallocate cost to that department. In the reciprocal allocation method the allocation of cost is made after solving the equation in which it recognizes the direct cost of the service department and the allocated cost of the department and the total cost of service department to be allocated is calculated. The total of service department cost will be allocated to the production departments.

Cost accounting system This is a system designed for inhouse or internal managers and their decision making. Cost accounting information is not needed for comparison with other companies. This information is commonly used in financial accounting also, but it is primarily used by company managers for their decision making. It is important that cost accounting information is relevant for the decision making of the manager. Cost allocation It is easy to calculate the cost of product if components of the products are directly used and not shared like direct labor is not shared resource. It becomes difficult to allocated the cost of common resources like depreciation on machine or rent of warehouse building which is used for two products manufacturing. Role of cost allocation comes into play when common cost needs to allocated to two or more products or departments. There different basis used for cost allocation like number units used, labors hours, area used by departments or products etc. Cost allocation base must be the one that best establishes the connection between the overhead incurred and the activity. Cause and effect basis can be effective way to identify cost allocation base. Step method of cost allocation Under step method of cost allocation, it is recognized that services of one service department are used other service departments. Once the service costs one department are allocated to other departments then the cost of other departments can be allocated to the department whose service cost are already allocated. For example, if the service cost IT department are allocated to administration, accounts and other departments, then service cost of administrative department can not be allocated back to IT department. The order of cost allocation depends on the percentage services offered by a service department to other service departments. Service department that contributes highest percentage of its services to other service departments, is ranked as first for cost allocation. Similar way, service department that has second highest service percentage to other service departments, is ranked as second. For example, after analyzing the allocation percentage of services of all service departments, it is found that IT department is offering 60% services to other service departments, Accounts is serving 50% services to other service departments and Administration department is serving 30% services to other service departments. Service costs of IT department are allocated first, service costs of accounts department are allocated second and service costs of administration department are allocated third. This is how, the order of cost allocation for service departments is decided under step method.

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