Quiz 8: Cost Allocation: Practices

Business

The company in question is producing two products of the same category - wines, one of which is having higher sales price and sales volume than the other. Both are manufactured from a single process i.e. crushing of grapes. Both the products have separate production facilities and selling and distribution organizations. The joint cost in this case is the cost of grapes $ 1,900,000 which is being allocated on the basis of percentage of juice used in each product. The major variable costs are packaging costs and labor costs. Two-third of selling and distribution expenditure is variable and one-third is fixed. General winery costs are fixed and are allocated to the products on the basis of number of cases produced. One-fourth of production facility cost is variable and three-fourth is fixed.It is observed that both the products have a positive contribution margin but Table Wines is showing a net loss after reducing the fixed costs. The break-even point of Table Wines is being achieved at triple the current sales volume. Hence the management is thinking of shutting down the production of Table Wines since it does not have the capacity to produce triple the current sales volume to achieve break even. It is given that if the production of Table Wines is discontinued then there won't be any effect on the sale of the other product Premium Wines. The table wine production facilities can be sold for $ 350,000 net of disposal costs. Also the grape juice currently being used to produce table wines can be sold to bulk purchasers for $ 150,000 per year. With the above background one has to decide whether to continue with the production of table wines or to discontinue the same. Also one has to calculate the costs which will continue to be incurred after the table wines production facility is closed and whether the benefits received from the sale of grape juice can offset these costs. The joint cost of grapes has been allocated on the basis of percentage of juice used in each product. One has to see how the allocation will change if the joint cost is allocated on the basis of net realizable value per unit. Net realizable value of a product is obtained by reducing the variable cost incurred after the split-off point from the sale price of the product. The variable and fixed cost components in selling and distribution expenditure and production facility cost has not been bifurcated in the problem. The variable cost per case, net realizable value and joint cost allocation is calculated below - img After separating the variable part of selling and distribution expenditure and production facility cost, one finds that the variable cost per case (excluding cost of grapes) of Premium Wines is $ 3.79 as compared to $ 4.00 computed by the accounting department of the company. Similarly the variable cost per case (excluding cost of grapes) of Table Wines is $ 3.01 as compared to $ 3.00 computed by the accounting department. Further the net realizable value of both the products is positive showing that both the products are able to fully recover their variable costs other than the cost of grapes. The joint cost of grapes is allocated based on the percentage of gross net realizable value. One finds that due to this higher joint cost is allocated to Premium Wines (91.17%) as compared to percentage of juice method (86.84%). The net profit after reducing the fixed costs and cost of grapes from the net realizable value is calculated below - img Thus one can see that Table Wines is showing a net profit now of $ 24,938 and the net profit of Premium Wines has been reduced to $ 665,237 from $ 750,000 calculated by the accounting department of the company. How did this happen This is because the company had not separated the production facility costs and selling and distribution expenditure into its fixed and variable components. Also the joint cost of grapes was being allocated on the basis of percentage of juice consumed instead of net realizable value. Due to this higher cost was being allocated to Table Wines and it was showing a net loss. Conclusion - Since the product Table Wines is showing a net profit after proper allocation of costs, it is suggested that the management of the company should not shut down the production of Table Wines. It is given that the management is thinking of discontinuing the production of Table Wines and selling the juice being used for production of table wines to bulk purchasers for $ 150,000 per year. It is to be noted that if this proposal is accepted then all the joint costs and fixed costs will have to be borne by the product Premium Wines. Only the variable costs which are being incurred for the product Table Wines will be saved due to this proposal. The feasibility of this proposal is shown in the below table - img The sale value of production facility of Table Wines $ 350,000 is not considered in the above calculation since it is a one-time income. Further the share of fixed production facility cost and fixed selling and distribution expenditure of Table Wines has to be borne by Premium Wines since the production facility of Table Wines is closed.From the above table one can see that the net profit of Premium Wines will be reduced from $ 665,237 calculated earlier to $ 563,408. The total profit of the company will also be reduced to $ 563,408 from $ 690,175 earlier. Conclusion - The proposal to discontinue production of Table Wines results in drop in the net profit of the company so it is suggested to management not to go ahead with this proposal.

An organization consists of various operating divisions and service departments. For example Company G has three operating divisions - division AB, division CD and division EF. Further it has three service departments - department S1, department S2, department S3. Each service department provides services to each of the operating divisions and also to the other service departments. To calculate the cost of production of the final product, the cost of the service departments has to be allocated to each of the operating divisions. There are different ways in which costs of service departments can be allocated to the operating divisions. In the question, direct allocation method and step-down allocation method are to be critically evaluated.Continuing with the example of Company G, the below table shows the percentage of each service department's capacity consumed by itself and other departments. img It can be seen that each service department consumes 5 percent of its own capacity internally and also uses the capacity of other service departments. The costs incurred by the service departments are as follows - img Direct allocation method Under this method, use of one service department's capacity by other service departments is not considered. Due to this the cost calculations are simplified but the calculated costs do not reflect the true picture as can be seen from the below table - img In the above table, the costs of each service department are allocated on the basis of the capacity usage of the department by the operating divisions. For example, the division AB uses 20 percent of department S1's capacity. Hence it is allocated $ 2 million of its cost ($10 million × 20%). In this way, after allocating the cost to the other divisions, one observes that only $ 6.5 million has been allocated out of the total cost of $ 10 million which leaves cost of $ 3.5 million unallocated. Similarly it is observed that department S2 and S3 have unallocated cost of $ 1.25 million and $ 2 million respectively. To fully allocate the costs of the service departments to the operating divisions, an allocation ratio is calculated based on the percentage of utilization of operating divisions only ignoring the capacity utilized by other service departments. This is called direct allocation method. The below table shows the recalculation of allocated costs to the operating divisions based on the direct allocation method. img As seen in Table 3 above, the total cost incurred by the service departments $ 23 million has been fully allocated to the three divisions. However the service provided (or service flowing) from one service department to another is totally ignored in this method. So the service departments are not charged anything for their use of the services of other service departments. This is the drawback of the direct allocation method which is sought to be rectified by the step-down allocation method. Step-down allocation method The shortcoming of the direct allocation method is partially rectified by the use of step-down allocation method. In this method, a particular service department is chosen and its costs are allocated to the other service departments and the operating divisions. Then another service department is chosen and its costs (including the share of costs allocated by the first service department) are allocated to the remaining service departments and the operating divisions. This process continues until all the service department costs flow to the other service departments and finally the entire service department costs are allocated to the operating divisions. Continuing with the above example, the revised allocation of service department costs using the step-down allocation method is as follows - img In the above table it is assumed that the costs of service department S1 are allocated first to other departments. In the first step the cost of service department S1 $ 10 million is allocated to divisions AB, CD and EF and also to the service departments S2 and S3. Next step is allocating the costs of department S2.The cost of service department S2 now includes $ 1.579 million allocated out of department S1. Thus the total cost of department S2 now becomes $ 6.579 million ($5 + $1.579). In the next step the cost of department S3 includes $ 1.579 million allocated from department S1 and $ 0.774 million from department S2. Thus the total cost to be allocated of department S3 becomes $ 10.353 million ($8 + $1.579 + $0.774). After the third step, the total cost allocated $ 23 million is matching with the actual total cost incurred by the service departments which shows that there are no unallocated costs. The direct allocation method ignores the fact that one service department may be providing service to the other service departments and hence in this method the service departments are not charged for the use by them of other service departments' resources. Under the step-down allocation method, one service department is chosen and its costs are allocated to other service departments also apart from being allocated to the operating divisions. However the first service department which is chosen does not bear any cost for the resources it uses of the other service departments. Hence this method does not represent a perfect allocation of the service department costs. However it still is better than the direct allocation method since the service departments other than the first choice department are charged for the services which they receive from the other service departments. Hence based on the above discussion one can conclude that the statement given in the problem is correct.

A manufacturing organization producing various products may have processes where two or more outputs are produced from a single input. Here the cost incurred for producing the multiple outputs from a single input is called a "joint cost" and the outputs are called "joint products". In such cases, the issue arises as to how the joint costs are to be allocated to the joint products. There are various ways of allocating joint costs to joint products. This can be done on the basis of physical weight, physical volume, relative sales value or net realizable value. The physical bases like weight and volume can be easily obtained since the organization usually keeps a record of the same and they don't change very frequently. In contrast the relative sales value method is difficult to obtain as the market prices keep on changing frequently. The net realizable value is the difference between sales revenue and the additional costs required to be incurred after split-off of the joint products. The advantage of net realizable value method is that it considers the relative profitability of the products while allocating the joint costs. Hence it can be used to decide whether it will be profitable to process a product further or to sell it as it is. a.The projected accounting profit of $ 420 million is allocated to the three activities - light distillates, processed heavy distillates and sold heavy distillates by allocating joint costs on physical volume basis as shown below - img Here it is to be noted that the activity Sold Heavy Distillates is incurring a projected loss of $ 50 million under this method.The projected accounting profit of $ 420 million is allocated to the three activities - light distillates, processed heavy distillates and sold heavy distillates by allocating joint costs on net realizable value basis as shown below - img Under net realizable value method all the three activities are earning profit. The ratio of accounting profit to net realizable value when joint costs are allocated on the basis of physical volume and on the basis of net realizable value is shown below - img b. The output of 60 million barrels of crude oil from West Texas Intermediate is 30 million barrels of Light Distillates and 30 million barrels of Heavy Distillates so there will not be any heavy distillates which are required to be sold as it is since the cat cracker machine has a capacity of 30 million barrels. The below table shows the calculation of net profit from the sale of Light Distillates and Processed Heavy Distillates when the price of crude oil has increased by $ 3.5 i.e. from $ 30 per barrel to $ 33.5 per barrel and assuming that other costs remain the same. img Based on the above analysis, one can conclude that Mr. Quilen has taken the right decision to switch from West Texas Intermediate to Kuwait Export when the price differential of crude oil reached $ 3.5 per barrel. At this price the total contribution is $ 285 million which is just about sufficient to cover the fixed costs of $ 270 million of Processed heavy distillates. The capacity of the cat cracker machine is 30 million barrels and it is operating at maximum capacity. Hence there is no scope to increase production. So if the contribution falls any further then the net profit will reduce further. The optimum point beyond which the Processed Heavy Distillates will become unprofitable is if the total contribution falls below the total fixed cost of $ 270 million. If the contribution per barrel falls below $ 9 ($ 270 million ÷ 30 million barrels) then the decision to switch the vendor of crude oil should be taken. c.If the capacity of the cracker machine is increased to 40 million barrels then it is given in the problem that the annual fixed costs will increase by $ 45 million. Hence the fixed costs of Processed Heavy Distillates would increase to $ 315 million (270 + 45). Hence the contribution per barrel should at least be $ 7.88 ( $ 315 million ÷ 40 million barrels) to break even. Answer - The optimum switching rule will be to switch as soon as the contribution per barrel falls below $ 7.88. d.If the cat cracking capacity of the refinery is increased to 40 million barrels and price differential per barrel remains $ 4, then the net profit is calculated as shown below - img Answer - Quillen should expand the cat cracking capacity of the refinery since the Processed Heavy Distillates are making a net profit of $ 45 million. e. As discussed in part c) of the solution, in case the refinery's cat cracking capacity is increased to 40 million barrels per year, then the contribution per barrel should at least be $ 7.88 for the refinery to break even in case of heavy distillates. If the price differential is only $ 3 then the contribution will easily cover the fixed costs since as observed in part d) above where the price differential is $ 4 and the net profit is $ 45 million. If the price differential is $ 5, then the contribution per barrel falls to $ 8 which is above $ 7.88 hence some profit will be earned by the refinery at this level. However if the price differential exceeds $ 5.12 per barrel then the refinery will start making losses. Hence if the price differential exceeds $ 5.12 per barrel then even if the capacity is expanded the refinery would make losses and hence in that case Quillen should decide not to expand.