Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 54

Cost Allocation—Ethical Issues

Star Buck, a coffee shop manager, has two major product lines—drinks and pastries. If Star allocates common costs on any objective basis discussed in this chapter, the drinks are profitable, but the pastries are not. Star is concerned that her boss will pull the plug on pastries. Star’s brother, who is struggling to make a go of his new business, supplies pastries to the coffee shop. Star decides to allocate all common costs to the drinks because, “Drinks can afford to absorb these costs until we get the pastries line on its feet.” After assigning all common costs to drinks, both the drinks and pastries product lines appear to be marginally profitable. Consequently, Star’s manager decides to continue the pastries line.

Required

a. How would you recommend Star allocate the common costs between drinks and pastries?

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b. You are the assistant manager and have been working with Star on the allocation problem. What should you do?

Step 1 of 2

a.

In the present case, Star, a coffee shop manager having two major product lines - drinks and pastries, allocates all the common cost of the shop to the drinks, because if he allocates the common costs to both of the products, the drinks are profitable but not the pastries. He is of the view that drinks can absorb these costs until we got the pastries line on its feet.

In general, all the common costs shall be allocated to all the cost objects, such as products, department, and customer. These costs are to be allocated on the basis of cost allocation rule which is a method or process used to assign the costs to the costs object. In the present case, if the common costs are allocated to both the products equally, drinks are profitable but not the pastries. It means, drinks is doing a business and it is a very profitable product. On the other hand, pastries is not doing good enough to make profits, because when the common costs are allocated, it is showing loss. In such a case, the common costs are to be allocated based on the revenues of the respective products. The product which is generating higher revenues should be allocated more common costs and the products with lower revenues shall be allocated lower common costs.

It is recommended to the manager that allocate the common costs to the products on the basis of their revenues. Products with higher revenues will be allocated higher costs, and products with lower revenue, shall be allocated with lower common costs.

Here, the manager should not allocate the entire common cost to drinks without allocating to pastries. He should allocate based on the product’s revenues. Common costs shall be allocated to both the products based on their revenues. If pastries are doing no business, in such case, it would be appropriate and recommended to allocate the entire common cost to drinks because of its profitability.