Cost and Management Accounting I

Chapter I. Fundamentals of Cost Accounting

1.1 Definition of Cost accounting and Managements accounting

Accounting is a major means of helping managers
a. To administer each of the activity or functional areas offer which they are
responsible and
b. To coordinate those functions within the framework of the organization as a whole.
Accounting provides information for three major purposes:
1. Routine internal reporting for the decisions of managers.
2. Non routine internal reporting for decisions of managers.
3. External reporting to investors, government authorities, and other outside parties on
the organization’s financial position, operations, and related activities.
Management Accounting
 Measures and reports financial and non financial information that helps managers to
fulfil the goals of the organization.
 Concerned with providing information to mangers, i.e. people inside the
organization who direct and control its operations.
 Focuses on internal reporting.
Financial Accounting
 Concerned with providing information to stockholders, creditors and other who are
outside the organization.
 Focuses on reporting to external parties.
 It measures and records business transactions and provides financial statements that
are based on GAAPs.

Managers are responsible for the financial statements issued to investors, government
regulators, and other outside parties. Therefore, managers are interested in both
management accounting and financial accounting.

1.2 Management Accounting Vs Financial Accounting

1
 Since planning is such an important part of the manager’s job, managerial
accounting has a strong future orientation. But financial accounting primarily
provides summaries of past financial transaction. The difficulty with
summaries of the past is that the future is not simply a reflection of what has
happened in the past. Changes are constantly taking place in economic
conditions, customer needs and so on.
 FA data are expected to be objective and verifiable. However, for internal
uses the manger wants information that is relevant even if it is not
completely objective or verifiable. By relevant, we mean appropriate for the
problem on hand.
 Timeliness is often more important than precision to managers. If decision
must be made, a manager would much rather has a good estimate now than
wait for a week for a more precise answer. In addition MA places
considerable weight on non monetary data. For example, information about
customer satisfaction is more important even though it is difficult to express
in monetary value.
 FA is primarily concerned with reporting for the company as a whole. But
MA primary focuses much more on the parts, or segments of a company.
These segments maybe product lines, sales territories, divisions, departments
or ant other categorization of the company’s activities that management finds
useful.
 FA statements prepared for external users must be prepared in accordance
with GAAPs. External users must have some assurance that the reports have
been prepared in accordance with some set of ground rules. MA is not bound
by GAAPs. Managers set their own ground rules concerning the content and
form of internal reports. The only constraint is that the expected benefits
from using the information should outweigh the cost of collecting, analyzing,
and summarizing the data.
 FA is mandatory; that is, it must be done. But MA is completely optional, so
the important question is always, “Is the information useful?” rather than, “Is
the information required?”

2
  The field of managerial accounting is less sharply defined. That is to say that
managerial accounting makes heavier use of economics, decision sciences,
and behavioural sciences. The field of financial accounting, in contrast, is
more sharply defined. This means that FA makes lighter use of related
disciplines.

Features Managerial Accounting Financial Accounting

Users of Information Managers at various levels Interested parties outside the
within the organization. organization.
Level of Aggregation Detailed information on Summarized information on
subunits within the the company as a whole
organization
Information type Economic any physical data Financial data
as well as financial data
Regulation Unregulated, limited only by Regulated by GAAP.
the value-added principle.
Information Characteristics Estimates that promote Factual information that is
relevance and enable characterized by objectivity,
timeliness. reliability, consistency, and
accuracy.
Time Horizon Past, present, and future Past only, historically based
Reporting Frequency Continuous reporting Delayed with emphasis on
annual reports
Sources of data The organization’s basic The organization’s basic
accounting system plus accounting system.
various other sources.
Delineation of activates Field is less sharply defined. Field is more sharply defined
Report Requirement Not mandatory Mandatory for external
reports
Cost Accountancy is an essential part of accountancy, which has been developed to meet
the managerial needs of business. Starting off as a branch of financial accounting, cost

3
accountancy has developed so fast in the last few decades that it is difficult to give suitable
definition, which fully covers its scope.
Further cost accountancy is regarded as the science, art and practice of s cost accountant.
 It is a science in the sense it is body of systematic knowledge having certain
principles, which a cost accountant should follow for the proper discharge of his
duties.
 It is an art, as it requires the ability and skill on the part of a cost accountant in
applying the principles of cost accountancy to various managerial problems.

 Cost Accounting primarily deals with collection, analysis of relevant cost data for
interpretation and presentation for various problems of management.
 Cost accounting is a management information system, which analyses past, present,
and future data to provide the basis for managerial decision making.

 According to Charles T. Horngren Cost Accounting is “a Quantitative method

that accumulates, classifies, summarizes, and interprets information for three major
purposes: (i) Operational planning and control (ii) Special decisions and (iii) product
decisions.
 In general, cost accounting is thus concerned with recording, classifying and
summarizing costs for determination of costs of products or services, planning,
controlling and reducing such costs and furnishing of information to management
for decision making.

Cost Accounting
 Provides information for both management accounting and financial accounting.
 It measures and reports financial and nonfinancial information that relates to the
cost of acquiring or consuming resources by an organization.
Includes those parts of both management accounting and financial accounting where cost
information is collected or analyzed

Thus Cost Accounting is concerned with

4
  Accounting the costs
 Controlling the costs
 Reducing the costs
Value chain
Value chain is the sequence of business functions in which customer usefulness is added
to products. Example six primary business functions: research and development, design,
production, marketing, distribution, and customer service. We illustrate
these business functions using Sony Corporation’s television division.
1. Research and development (R&D)—Generating and experimenting with ideas
related to new products, services, or processes. At Sony, this function includes research
on alternative television signal transmission (analog, digital, and high-definition) and on
the clarity of different shapes and thicknesses of television screens.
2. Design of products and processes. Detailed planning, engineering, and testing of
products and processes. Design at Sony includes determining the number of component
parts in a television set and the effect of alternative product designs on quality
and manufacturing costs. Some representations of the value chain collectively refer to
the first two steps as technology development.
3. ProductionProcuring, transporting and storing (also called inbound logistics),
coordinating, and assembling (also called operations) resources to produce a product
or deliver a service. Production of a Sony television set includes the procurement and
assembly of the electronic parts, the cabinet, and the packaging used for shipping.
4.Marketing (including sales)Promoting and selling products or services to customers
or prospective customers. Sony markets its televisions at trade shows, via advertisements
in newspapers and magazines, on the Internet, and through its sales force.
5. DistributionProcessing orders and shipping products or services to customers (also
called outbound logistics). Distribution for Sony includes shipping to retail outlets,
catalog vendors, direct sales via the Internet, and other channels through which customers
purchase televisions.
6. Customer service providing after-sales service to customers. Sony provides customer
service on its televisions in the form of customer-help telephone lines, support on the
Internet, and warranty repair work.

5
In addition to the six primary business functions, Example an administrative
function, which includes functions such as accounting and finance, human resource
management, and information technology, that support the six primary business
functions.
When discussing the value chain in subsequent chapters of the book, we include the
administrative support function within the primary functions. For example, included in
the marketing function is the function of analyzing, reporting, and accounting for
resources spent in different marketing channels, while the production function includes
the human resource management function of training front-line workers.
Each of these business functions is essential to companies satisfying their customers
and keeping them satisfied (and loyal) over time. Companies use the term
customer relationship management (CRM) to describe a strategy that integrates people
and technology in all business functions to deepen relationships with customers, partners,
and distributors. CRM initiatives use technology to coordinate all customer-facing
activities (such as marketing, sales calls, distribution, and post sales support) and the
design and production activities necessary to get products to customers.
At different times and in different industries, one or more of these functions is more
critical than others. For example, a company developing an innovative new product or
operating in the pharmaceutical industry, where innovation is the key to profitability, will
emphasize R&D and design of products and processes. A company in the consumer
goods industry will focus on marketing, distribution, and customer service to build its
brand. depicts the usual order in which different business-function activities
physically occur. Do not, however, interpret Exhibit 1-2 as implying that managers
should
proceed sequentially through the value chain when planning and managing their activi-
ties. Companies gain (in terms of cost, quality, and the speed with which new products
are
developed) if two or more of the individual business functions of the value chain work
concurrently as a team. For example, inputs into design decisions by production, market-
ing, distribution, and customer service managers often lead to design choices that reduce
total costs of the company.

6
Managers track the costs incurred in each value-chain category. Their goal is to
reduce costs and to improve efficiency. Management accounting information helps man-
agers make cost-benefit tradeoffs. For example, is it cheaper to buy products from outside
vendors or to do manufacturing in-house? How does investing resources in design and
manufacturing reduce costs of marketing and customer service

Decision Making , Planning and control

a five-step decision-making process using the example of the
Daily News
, newspaper in Boulder, Colorado. Subsequent chapters of the book describe how man-
agers use this five-step decision-making process to make many different types of
decisions.
The
Daily News differentiates itself from its competitors based on in-depth analyses of
news by its highly rated journalists, use of color to enhance attractiveness to readers and
advertisers, and a Web site that delivers up-to-the-minute news, interviews, and analyses.
It has substantial capabilities to deliver on this strategy, such as an automated, computer-
integrated, state-of-the-art printing facility; a Web-based information technology infra-
structure; and a distribution network that is one of the best in the newspaper industry.
To keep up with steadily increasing production costs, Naomi Crawford, the manager
of the
Daily News, needs to increase revenues. To decide what she should do, Naomi
works through the five-step decision-making process.
1. Identify the problem and uncertainties.
Naomi has two main choices:
a. Increase the selling price of the newspaper, or
b. increase the rate per page charged to advertisers.
The key uncertainty is the effect on demand of any increase in prices or rates. A decrease
in demand could offset any increase in prices or rates and lead to lower overall revenues.
2. Obtain information.
Gathering information before making a decision helps managers

7
gain a better understanding of the uncertainties. Naomi asks her marketing manager to
talk to some representative readers to gauge their reaction to an increase in the news-
paper’s selling price. She asks her advertising sales manager to talk to current and
potential advertisers to assess demand for advertising. She also reviews the effect that
past price increases had on readership. Ramon Sandoval, the management accountant
at the
Daily News, presents information about the impact of past increases or decreases
in advertising rates on advertising revenues. He also collects and analyzes information
on advertising rates charged by competing newspapers and other media outlets.
3. Make predictions about the future.
On the basis of this information, Naomi makes predictions about the future. She
concludes that increasing prices would upset readers and decrease readership. She has a
different view about advertising rates. She expects a market-wide increase in advertising
rates and believes that increasing rates will have little effect on the number of advertising
pages sold.
Naomi recognizes that making predictions requires judgment. She looks for
biases in her thinking. Has she correctly judged reader sentiment or is the negative
publicity of a price increase overly influencing her decision making? How sure is she
that competitors will increase advertising rates? Is her thinking in this respect biased
by how competitors have responded in the past? Have circumstances changed? How
confident is she that her sales representatives can convince advertisers to pay higher
rates? Naomi retests her assumptions and reviews her thinking. She feels comfortable
with her predictions and judgments.
4. Make decisions by choosing among alternatives.
When making decisions, strategy is a vital guidepost; many individuals in different parts
of the organization at different times make decisions. Consistency with strategy binds
individuals and timelines together and provides a common purpose for disparate
decisions. Aligning decisions with strategy enables an organization to implement its
strategy and achieve its goals.
Without this alignment, decisions will be uncoordinated, pull the organization in different
directions, and produce inconsistent results. Consistent with the product differentiation

8
strategy, Naomi decides to increase advertising rates by 4% to $5,200 per page in March
2011. She is confident that the Daily News ’s distinctive style and Web presence will
increase readership, creating value for advertisers. She communicates the new advertising
rate schedule to the sales department. Ramon estimates advertising revenues of
$4,160,000 ($5,200 per page
5. Implement the decision, evaluate performance, and learn.
Managers at the Daily
Take actions to implement the March 2011 budget. Management accountants collect
information to follow through on how actual performance compares to planned or
budgeted performance (also referred to as scorekeeping).
Information on actual results is different from the pre-decision planning information
Naomi collected in Step 2, which enabled her to better understand uncertainties, to make
predictions, and to make a decision. The comparison of actual performance to budgeted
performance is the control or post-decision role of information.
Control comprises taking actions that implement the planning decisions, deciding how to
evaluate performance, and providing feedback and learning to help future decision
making. Measuring actual performance informs managers how well they and their sub-
units are doing. Linking rewards to performance helps motivate managers. These
rewards are both intrinsic (recognition for a job well-done) and extrinsic (salary,
bonuses, and promotions linked to performance). A budget serves as much as a con-
trol tool as a planning tool. Why? Because a budget is a benchmark against which
actual performance can be compared.

Cost-Benefit Approach
Managers continually face resource-allocation decisions, such as whether to purchase a
new software package or hire a new employee. They use a cost-benefit approach when
making these decisions: Resources should be spent if the expected benefits to the
company exceed the expected costs. Managers rely on management accounting
information to quantify expected benefits and expected costs although all benefits and
costs are not easy to quantify. Nevertheless, the cost-benefit approach is a useful guide
for making resource-allocation decisions. Consider the installation of a company’s first
budgeting system. Previously, the company used historical recordkeeping and little

9
formal planning. A major benefit of installing a budgeting system is that it compels
managers to plan ahead, compare actual to budgeted information, learn, and take
corrective action. These actions lead to different decisions that improve performance
relative to decisions that would have been made using the historical system, but the
benefits are not easy to measure. On the cost side, some costs, such as investments in
software and training are easier to quantify. Others, such as the time spent by managers
on the budgeting process, are harder to quantify.
Regardless, senior managers compare expected benefits and expected costs, exercise
judgment, and reach a decision, in this case to install the budgeting system.
Behavioral and Technical Considerations
The cost-benefit approach is the criterion that assists managers in deciding whether, say,
to install a proposed budgeting system instead of continuing to use an existing historical
system. In making this decision senior managers consider two simultaneous missions:
one technical and one behavioral. The technical considerations help managers make wise
economic decisions by providing them with the desired information (for example, costs
in various value-chain categories) in an appropriate format (such as actual results versus
budgeted amounts) and at the preferred frequency. Now consider the human (the
behavioral) side of why budgeting is used. Budgets induce a different set of decisions
within an organization because of better collaboration, planning, and motivation. The
behavioral considerations encourage managers and other employees to strive for
achieving the goals of the organization.
Both managers and management accountants should always remember that management
is not confined exclusively to technical matters. Management is primarily a human
activity that should focus on how to help individuals do their jobs better—for example,
by helping them to understand which of their activities adds value and which does not.
Moreover, when workers underperform, behavioral considerations suggest that
management systems and processes should cause managers to personally discuss with
workers ways to improve performance rather than just sending them a report high
lighting their underperformance.
Different Costs for Different Purposes
This book emphasizes that managers use alternative ways to compute costs in different

10
decision-making situations, because there are different costs for different purposes. A
cost concept used for the external-reporting purpose of accounting may not be an
appropriate concept for internal, routine reporting to managers.
Consider the advertising costs associated with Microsoft Corporation’s launch of a major
product with a useful life of several years. For external reporting to shareholders,
television advertising costs for this product are fully expensed in the income statement in
the year they are incurred. GAAP requires this immediate expensing for external
reporting. For internal purposes of evaluating management performance, however, the
television advertising costs could be capitalized and then amortized or written off as
expenses over several years. Microsoft could capitalize these advertising costs if it
believes doing so results in a more accurate and fairer measure of the performance of the
managers that launched the new product.
We now discuss the relationships and reporting responsibilities among managers and
management accountants within a company’s organization structure.
ORGANIZATION STRUCTURE AND THE MANAGEMENT ACCOUNTANT
Organization Structure and the Management Accountant
We focus first on broad management functions and then look at how the management
accounting and finance functions support managers.
Line and Staff Relationships
Organizations distinguish between line management and staff management.
 Line management
, such as production, marketing, and distribution management, is directly responsible for
attaining the goals of the organization. For example, managers of manufacturing
divisions may target particular levels of budgeted operating income, certain levels of
product quality and safety, and compliance with environmental laws. Similarly, the
pediatrics department in a hospital is responsible for quality of service, costs, and patient
billings.
 Staff management
, such as management accountants and information technology and human-resources
management, provides advice, support, and assistance to line management. A plant
manager (a line function) may be responsible for investing in new equipment. A

11
management accountant (a staff function) works as a business partner of the plant
manager by preparing detailed operating cost comparisons of alternative pieces of
equipment.
Increasingly, organizations such as Honda and Dell are using teams to achieve their
objectives. These teams include both line and staff management so that all inputs into a
decision are available simultaneously.

12
Chapter 2: Basic cost terms and concepts

1.2Concepts and classifications of cost

Costs, Expenses and Losses
 Cost is defined as the monetary value of goods and services expended to obtain
current or future benefits.
 Expenses are expired costs for which benefits have already been received in the
current fiscal period. Expenses are deductible from revenue.
 Losses sacrifices without any benefit. Loss can be defined as the excess of all
expenses over revenues for a period.
o Accountants define cost as a resource sacrificed or forgone to achieve a specific
objective. It is usually measured as the monetary amount that must be paid to
acquire goods or services.
o An actual cost is the cost incurred (a historical cost) as distinguished from budgeted
or forecasted costs.
General Cost Classifications
A. Manufacturing Costs
 Direct Materials
Raw materials refer to any materials that are used in the final product; and finished product
of one company can become the raw materials of another company.
Direct materials are those materials that become an integral part of the finished product and
that can be physically and conveniently traced to it. This would include for example the
seats Boeing purchases from subcontractors to install in its commercial aircrafts.
Those that can not be traceable to the final product are called indirect materials. This can
be glue used to assemble a chair.
 Direct Labor
The term direct labor is reserved for those labor costs that can be easily i.e. physically and
conveniently traced to individual units of product. Direct labor is sometimes called touch
labor, since direct labor workers typically touch the product while it is being made.
Labor costs that cannot be physically traced to the creation of products, or that can be traced
only at great costs and inconvenience, are termed as indirect labor and treated as part of
manufacturing overhead. It includes the labor costs of janitors, supervisors, material
handlers, and night security guards.
 Manufacturing Overhead
Includes all costs of manufacturing except direct materials and direct labor.
Manufacturing overhead includes items such as
 indirect materials;
 indirect labor
 maintenance and repairs on production equipment
 heat and light
 property taxes
 depreciation and insurance on manufacturing facilities.
A company also incurs costs for heat and light, property taxes, insurance, depreciation, and
so forth associated with its selling and adminstatrative functions but these cots are not
included as part of manufacturing overhead. Only those costs associated with operating the
factory is included the manufacturing overhead category.

13
Manufacturing overhead is also called indirect manufacturing cost, factory overhead and
factory burden
Direct Material + Direct Labor = Prime Cost
Direct Labor + Manufacturing Overhead = Conversion Cost1

Ex2-1: Classify the following as direct materials, direct labor, or factory overhead:
a. Glue used in the manufacture of desks
b. Labor of a janitor
c. Factory utilities
d. Wood used in the manufacture of a table
e. Labor of a machinist

B. Non-manufacturing Costs
Generally, non-manufacturing costs are sub classified into two categories:
 Marketing or selling costs: include all cost categories to secure customer orders and
get the finished product or service into the hands of the customer. These costs are
often called order-getting and order filling costs. Like advertising, shipping, sales
travel, sales commissions, sales salaries, and costs of finished goods warehouses.
 Administrative Costs: include all executive, organizational associated with the
general management of an organization rather than with manufacturing, marketing
or selling. Like executive compensation, general accounting, secretarial, public
relations, and similar costs involved in the overall, general administration of the
organization as a whole.
Cost Classifications on financial Statements
The Balance Sheet
The balance sheet or statement of financial position, of a manufacturing company is similar
to that of a merchandising company. However there are differences in the inventory
accounts.
A merchandising company has only one class of inventory- goods purchased from suppliers
that are awaiting resale to customers. By contrast, manufacturing companies have three
classes of inventories:
o Raw materials: shows the cost of raw materials on hand and intended for use in the
manufacturing process.
o Work in process: shows the cost of goods in the manufacturing process, but not
completed at the end of the accounting period.
o Finished goods: shows the cost of the goods completed and ready for sale.

The Income Statement

1
This term stems from the fact that direct labor costs and overhead costs are incurred in the conversion of
materials into finished products.

14
 Merchandising Company
Sales xxx
Cost of goods sold
Beginning merchandise inventory xxx
Add Purchases xxx
Goods available for sale xxx
Deduct: Ending merchandise inventory xxx xxx
Gross Margin xxx
Less: Operating Expenses
Selling Expenses xxx
Administrative Expenses xxx xxx
Net Income xxx
Manufacturing Company
Sales xxx
Cost of goods sold
Beginning finished goods inventory xxx
Add: Cost of goods manufactured xxx
Goods available for sale xxx
Deduct: Ending finished goods inventory xxx xxx
Gross Margin xxx
Less operating expenses:
Selling Expenses xxx
Administrative Expenses xxx xxx
Net income xxx

Schedule of Cost of Goods Manufactured

Direct Materials
Beginning raw materials inventory xxx
Add: Purchases of raw materials xxx
Raw materials available for use xxx
Deduct: Ending raw materials inventory xxx
Raw materials used in production xxx
Direct Labor xxx
Manufacturing overhead
Insurance, factory xxx
Indirect labor xxx
Machine rental xxx
Utilities, factory xxx
Supplies xxx
Depreciation, factory xxx
Property taxes, factory xxx
Total manufacturing costs xxx
Add: Beginning work in process inventory xxx
Total goods in production xxx
Deduct: ending work in process inventory xxx
Cost of goods manufactured xxx

15
Ex 2-2: The following cost data relate to Taylor Products Company for the year ended
June 30, 2005.
Direct Materials $ 55,600
Direct Labor 72,400
Factory Overhead 36,500
Work in process inventory, July 1, 2004 38,200
Work in process inventory, June 30, 2005 34,800
Required:
1. Calculate the manufacturing costs for the year.
2. Calculate the cost of goods manufactured for the year.

Ex 2-3: Iowa Products Company accumulated the following data for 2005.
Jan 1, 2005 Dec 31, 2005
Inventories:
Finished Goods $ 52,000 $ 54,000
Work in Process 29,600 27,800
Raw materials 14,200 15,000
Direct labor 95,000
Raw material purchases 138,000
Indirect labor 15,300
Indirect materials and supplies 10,800
Factory utilities 18,600
Depreciation expense- Factory 14,000
Factory rent 18,000
Payroll taxes- Factory wages 8,100
Repairs and maintenance 6,000
Insurance expense- Factory 6,800
Miscellaneous factory expenses 5,200
Sales 710,000
Sales discount 12,000
Selling expenses 95,600
General expenses 75,300
Interest expenses 7,000
Required:
1. Prepare a statement of cost of goods manufactured.
2. Prepare an income statement (assume an income tax rate of 25%)

Product Costs versus Period Costs

 Product Costs
o Product costs include all cots that are involved in acquiring or making product- dirct
materials, direct labor, and manufacturing overhead.
o Initially product costs are assigned to an inventory account on the balance sheet.
When goods are sold, the costs are released from inventory as expenses (cost of
goods sold) and matched against revenue. For this reason they are also known as
inventoriable costs.

16
 o Product costs are not necessarily treated as expenses in the period in which they are
incurred. Rather they are treated as expenses in the period in which the related
products are sold. This means that a product cost such as direct materials or direct
labor might be incurred during one period but not treated as an expense until a
following period when the completed product is sold.
 Period Costs
o Period costs are all the costs that are not included in product costs. These costs are
expensed on the income statement in the period, in which they are incurred, the rules
of accrual accounting.
o Period costs are not included as part of the cost of either purchased or manufactured
goods like sales commissions and office rent and all selling and adminstatrative
expenses are considered to be period costs.

Cost Classification for Predicting Cost Behaviour

Cost behaviour mans how a cost will react or respond to changes in the level of business
activity. As the activity level rises and falls, a particular cost may rises and fall as well or it
may remain constant.
 Variable Cost
 A variable cost is a cost that varies, in total, in direct proportion to change in the
level of activity. The activity can be expressed in many ways such as units produced,
units sold, miles driven, beds occupied, hours worked and so on.
 A good example of a variable cost is direct materials. The cost of direct materials
used during a period will vary, in total, in direct proportion to the number of units
that are produced.
 In variable cost, the total cost rises and falls as the activity level rises and falls. One
interesting aspect of variable cost behaviour is that a variable cost is constant if
expressed on a per unit basis.
Let’s assume that we manufacture autos, each auto requires a battery that costs Br. 24 each.
If only 1 auto is manufactured the total variable cost for batteries is Br. 24.

No. of Autos Produced Cost for Battery Total VC-Batteries

1 Br. 24 Br. 24
500 24 12,000
1,000 24 24,000

 Fixed Cost
 A fixed cost is a cost that remains constant in total regardless of changes in the level
of activity. Unlike variable costs, fixed costs are not affected by changes in activity.
 Consequently, as the activity level rises and falls, the fixed costs remain constant in
total amount unless influenced by some outside force, such as price changes.
E.g.:- Rent Expense
 When we say a cost is fixed, we mean it is fixed within some relevant range. The
relevant range is the range of activity within which the assumptions about variable
and fixed costs are valid.

17
  Fixed costs can create difficulties if it becomes necessary to express the costs on per
unit basis. This is because if fixed costs are expressed on a per unit basis, they will
react inversely with changes in activity.

Monthly Rental Cost No. of Tests Performed Average Cost per Test
Br. 8,000 10 Br. 800
8,000 500 16
8,000 2000 4

Behaviour of the Cost (within the relevant range)

Cost In Total Per Unit

Variable Cost Total variable cost increases Variable cost remains
and decreases in proportion constant per unit.
to changes in the activity
level.
Fixed Cost Total fixed cost is not Fixed costs decrease per unit
affected by changes in the as the activity level rises and
activity level within the increase per unit as the
relevant range. activity level falls.

Ex: 2-4: Classify the following as variable cost or fixed cost.

a. President’s salary
b. Direct labor
c. Straight-line depreciation on factory building
d. Commissions paid to sales persons.
e. Direct material
f. Advertising

Ex 2-5: Guild Company manufactures and sells one product. The production can vary from
20,000 to 60,000 units. A partially schedule of the company’s total and per unit costs for the
coming year follows:
Units produced and sold
20,000 40,000 60,000
Total costs:
Variable costs $ 80,000 ? ?
Fixed costs 100,000 ? ?
Total costs $ 180,000 ? ?
Cost per unit:
Variable cost ? ? ?
Fixed cost ? ? ?
Total cost per unit ? ? ?
Required:
1. Compute the schedule for Guild Company’s total and per unit costs.
2. Determine the cost formula in the format of Y=a + bx

18
Cost Classification for Assigning Costs to Cost Object
 A cost object is anything for which cost data are desired- including products,
product lines, customers, jobs, and organizational subunits or which is anything for
which a separate measurement of costs is desired. For the purpose of assigning costs
to cost objects, costs are classified as either direct or indirect.
 A costing system typically accounts for costs in two basic stages- accumulation and
then assignment.
 Cost accumulation is the allocation of cost data in some organized way by means of
an accounting system.
 Coat assignment is a general term that includes both (1) tracing accumulated costs
to a cost object, and (2) allocating accumulated cost to cost object
 A key question in cost assignment is whether costs have direct or an indirect
relationship to a particular cost object.

 Direct Cost
A direct cost is a cost that can be easily and conveniently traced to the particular cost object
under consideration. The concept of direct cost extends beyond just direct material and
direct labor.

 Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost
object under consideration. To be traced to a cost object such as a particular product, the
cost must be caused by the cost object.
The term cost allocation is used to describe the assignment of indirect costs to a particular
cost abject.
A common cost is a cost that is common to a number of costing objects but cannot be traced
to them individually. A common cost is a particular type of indirect cost.

Cost Classification for Decision Making

Costs are an important feature of many business decisions. In making decisions, it is
essential to have a firm grasp of the concepts of differential cost, opportunity cost, and sunk
costs.

 Differential Cost and Revenue

 A difference in cost between any two alternatives is known as a differential cost. A
difference in revenue between ant two alternatives is known as differential revenue.
 A differential cost is also known as an incremental cost, although technically an
incremental cost should refer only to an increase in cost from one alternative to
another; decrease in cost should be referred to as decremental costs. Differential cost
is a broader term, encompassing both cost increases (incremental cost) and cost
decreases (decremental cost) between alternatives.
 The accountant’s differential cost concept can be compared to the economist’s
marginal cost concept. The revenue that can be obtained from selling one more unit
of product is called marginal revenue, and the cost involved in producing one more
unit of product is called marginal cost.

19
  Differential cost can be either fixed or variable.

 Opportunity Cost
 Opportunity cost is the potential benefit that is given up when one alternative is
selected over another.
 Opportunity cost is not usually entered in the accounting records of an
organization, but it is a cost that must be explicitly considered in every decision
a manager makes.

Example: - Vicki has a part-time job that pays $100 per week while attending college.
She would like to spend a week at the beach during spring break, and her employer has
agreed to give her the time off, but without pay. The $100 in lost wages would be an
opportunity cost of taking the week off to be at the beach.

 Sunk Cost
A sunk cost is a cost that has already been incurred and that cannot be changed by any
decision made now or in the future. Since sunk costs cannot be changed by any decision,
they are not differential costs. Therefore, they can and should be ignored when making a
decision.

20
Chapter 4 : Cost Allocation

Cost Allocation is an inescapable problem in nearly every organization and in nearly

every aspect of accounting.

Purposes of Cost Allocation

1. To provide information for economic decisions.
2. To motivate managers and other employees.
3. To justify costs or compute reimbursement.
4. To measure income and assets for reporting to external parties.

I. Allocating Costs from One Department to Another.

There are several issues to consider when allocating costs:
 Should different methods of allocation be used for fixed costs and for variable
costs,
 Should budgeted rates or actual rates be used, and
 Should budgeted quantities or actual quantities be used?

Single-Rate and Dual-Rate Methods

The single-rate allocation method pools all costs in one cost pool and allocates theses
costs to cost objects using the same rate per unit of the single allocation base. There is no
distinction between costs in a cost pool in terms of cost behavior, such as fixed costs
versus variable costs.

The dual-rate cost allocation method classifies costs in each cost pool into to sub cost
pools, a variable cost pool and a fixed cost pool. Each of these pools uses a different cost
allocation base.

Example:
Sand Hill Co. has a Central Computer Department; the department has two users,
Microcomputer Division and Peripheral Equipment Division. The following data apply to
the coming budget year.
Fixed costs of operating the computer facility in the 6000-18000hr relevant
range Br3, 000,000/year
Total capacity available 18,000hrs
Budgeted long-run usage
Microcomputer Division 8,000hrs
Peripheral Equipment Division 4,000hrs
Total 12,000hrs
Budgeted variable cost per hour $200/hour used
Assume during the year the Microcomputer uses 9,000 hrs and Peripheral Equipment
uses 3,000 actual hours.

21
1. Single Rate Allocation Method
Total cost pool =3,000,000+200*12,000 5,400,000
Budgeted usage 12,000hrs

Budgeted totals rate per hour= 5,400,000 = Br.450/hr

12,000hrs
Allocation rate for Microcomputer Division Br. 450/hr
Allocation rate for Peripheral Division Br. 450/hr

Microcomputer=9000*450= Br. 4,050,000.

Peripheral Equipment= 3000*450= Br.1, 350,000.

2. Dual-rate Allocation Method

Allocation of Fixed Costs to:

Microcomputer Division = 8000/1200hrs * 3,000,000 = Br. 2,000,000/year.
Peripheral Equipment Division = 4000/12000hrs * 3,000,000 = Br. 1,000,000/year.

Microcomputer: 2,000,000 + (200*9000) = Br. 3,800,000.

Peripheral Equipment: 1,000,000 + (200*3000) = Br. 1,600,000.

II. Allocating Support Departments

Operating and Support Departments

Operating Department (Production Department) adds value to a product or service that
is observable by a customer.
Support Departments (Service Department) provide the service that assists other
internal departments.

Support Department creates a special cost allocation problem when they provide
reciprocal support to each other as well as support to operating departments.
Methods:
1. Direct Allocation Method
2. Step-Down Allocation Method
3. Reciprocal Allocation Method

Example: ABC Engineering has two Support Departments and Two operating
Departments. Costs are accumulated in each department for planning and control
purposes.
Support Departments Operating Departments
Plant Maintenance Machining
Information Systems Assembly
The two support departments provide reciprocal support to each other as well as to the
two operating departments. Costs are accumulated in each department for planning and
control purpose.

22
 Support Departments Operating Departments
Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Support work finished
By plant maintenance
Budgeted labor hrs - 1,600 2,400 4,000 8,000
Percentage - 20% 30% 50% 100%
By Infor. System.
Budgeted com. Hrs 200 - 1600 200 200
Percentage 10% - 80% 10% 100%

Required: Allocate costs using the three methods.

1. Direct Allocation Method
This method is the most widely used method of allocating support department
costs. This method allocates each support department costs directly to the
operating departments.

Plant Maintenance Machining

Information Systems Assembly

Support Departments Operating Departments

Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (600,000) 225,000 375,0

(2400/6400, 4000/6400)
Allocation by Inf. Syste. 0 (116,000) 103,111 12,889
(1600/1800, 200/1800)
Total Budgeted MOH of 0 $728,111 $578,889 $1,316,000

23
Operating departments

Advantage of this method:

 Simplicity
 No need to predict the usage of support department service by other
support departments.
Disadvantage
 Failure to recognize reciprocal services provided among support
departments.

2. Step-Down Allocation Method (Sequential Allocation Method)

 Allows the partial recognition of the service rendered by support
departments to other support departments.
 This method requires the support departments to b ranked (sequenced) in
order that the step-down allocation is to proceed. Different sequences will
result in different allocation of support department costs to operating
departments.
 Popular step-down begins with the support department that renders the
highest percentage of its total services to other support departments and so
on, ending with the support department that renders the lowest percentage
of its total services to other support departments.

Plant Maintenance Machining

Information Systems Assembly

Support Departments Operating Departments

Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (600,000) 120,000 180,000 300,000
(1600/8000, 2400/8000, 4000/8 ::)000) 236,000
Allocation by Inf. Syste. 0 (236,000) 209,778 26,222
(1600/1800, 200/1800)
Total Budgeted MOH of 0 $789,778 $526,222 $1,316,000
Operating departments

24
Note: The step-down method does not recognize the total services that support
department provide to each other.

3. Reciprocal Allocation Method

 Allocates cost by explicitly including the mutual services provided among
all support departments.
 Conceptually the direct method and the step-down allocation method are
less accurate than the reciprocal method when the support departments
provide service to another reciprocally.
 The reciprocal method enables us to incorporate interdepartmental
relationships fully not the support department cost allocations.
 Implementing the reciprocal allocation method requires three steps:

1. Express Support Department Costs and support department reciprocal

relationships in the from of Linear Equation.
Let PM be the completed reciprocated costs2 of Plant Maimtance and IS be
the complete reciprocated costs to Information Systems.

PM = $600,000 + 0.1 IS
IS = $116,000 + 0.2 PM

2. Solve the cost of linear equation to obtain the complete reciprocated costs
of each support departments.

PM = 600,000 + 0.1 (116,000 + 0.2PM)

PM = 600,000 + 11,600 + 0.02PM
0.98PM = 616,000
PM = $624,082

IS = 116,000 + 0.2(624,082)
IS = $ 240,816
3. Allocate the complete reciprocated costs of each department to all other
departments (both support department and operating departments).

Plant Maintenance Machining

Information Systems Assembly

2
Complete reciprocated cost mean the support departments own cost plus any interdepartmental cost
allocations.

25
 Support Departments Operating Departments
Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (624,082) 124,816 187,225 312,041
(1600/8000, 2400/8000, 4000/8000)

Allocation by Inf. Syste. 24,082 (240,816) 192,652 24,082

(200/2000 1600/2000, 200/2000)
Total Budgeted MOH of 0 0 $779,877 $536,123 $1,316,000
Operating departments

26
Chapter 5: Cost Allocation: Joint Products and Byproducts

Terms

 Joint costs are the costs of a single production process that yields multiple
products simultaneously.
 The Split-off point is the juncture in a joint production process where one or
more products become separately identifiable.
 Separable costs are all costs of manufacturing, marketing, distribution, and so on.
Incurred beyond the split off point those are assignable to one or more individual
products.
At or beyond the split off point, decisions relating to sale or further processing of
individual products can be made independently of decisions about other products.
The outputs of a joint production process can be classified into two general categories-
those with a positive sales value and those with a zero sales value. A product is any
output that has a positive net sales value (or an output that enables an organization to
avoid incurring costs).
 A joint product has relatively high sales value compared to other products yielded
by a joint production process
 When a joint production process yields only one product with a relatively high
sales value, the product is termed as main product.
 A byproduct has a relatively low sales value compared with the sales value of a
joint or main product.

Approaches to Allocating Joint Costs

Approach 1: Allocate costs using market based data such as revenues.
 Sales value at splitoff point
 Estimated net realizable value (NRV) method
 Constant gross-margin percentage NRV method
Approach 2: Allocate costs using physical-measure-based data such as weight or volume.

Example1: Farmers Dairy purchases raw milk from individual farms and processes it
until the splitoff point, where two products (cream and liquid skim) emerge. These two
products are sold to an independent company, which markets and distributes them to
supermarkets and other retail outlets.
 Raw milk processed 100,000 gallons. 10,000 gallons of raw milk are lost in the
production process due to evaporation, spoilage, and the like, yielding 100,000
gallons of good product.
Production Sales
Cream 25,000 gallons 20,000 gallons at Br. 8/gallon
Liquid skim 75,000 gallons 30,000 gallons at Br. 4/gallon
 Inventories
Beginning Inv Ending Inv

27
 Raw milk 0 gallons 0 gallons
Cream 0 gallons 5,000 gallons
Liquid skim 0 gallons 45,000 gallons
 Cost of purchasing 110,000 gallons of raw milk and processing it until the splitoff
point to yield 25,000 gallons of cream and 75,000 gallons of liquid skim, Br.
400,000.
How much of the joint costs of Br.400,000 should be allocated to the cost of goods sold
(20,000 gallons of cream and 30,000 gallons of liquid skim) and to the ending inventory
(5,000 gallons of cream and 45,000 gallons of liquid skim)?

1. Sales value at splitoff point

 Allocates joint costs to joint products on the basis of a relative sales value
at the splitofff point of the total production of these products during the
accounting period.

Cream Liquid Skim Total

1. Sales value at splitoff point (cream, Br.200,000 Br.300,000 Br.500,000
25,000 gall.*Br.8; liquid skim, 75,000
Gall.*Br.4)
2. Weighting (Br.200,000/Br.500,000; 0.40 0.60
Br.300, 000/Br.500, 000)
3. Joint cost allocated (cream, 0.40* Br.160, 000 Br.240, 000 Br.400, 000
Br.400, 000; liquid skim, 0.60*Br.400, 000
4. Joint production cost per gallon (cream, Br. 6.40 Br.3.20
Br.160, 000/25,000 gall; liquid skim,
Br.240, 000/75,000 gall.)

Note that the method uses the sales value of the entire production of the accounting
period. The reason is that the joint costs were incurred on all units produced, not just
those sold in the current period.

2. Physical-Measure Method
 Allocates joint costs to joint products on the basis of the relative weight,
volume, or other physical measure at the splitofff point of the total
production of these products during the accounting period.
Cream Liquid Skim Total
1. Physical measure of production (gall.) Br.200, 000 Br.300, 000 Br.500, 000
2. Weighting (25,000gall/100,000 gall; 0.25 0.75
75,000gall/100,000gall)
3. Joint cost allocated (cream, 0.25* Br.100, 000 Br.300, 000 Br.400, 000
Br.400, 000; liquid skim, 0.75*Br.400, 000
4. Joint production cost per gallon (cream, Br. 4 Br.4
Br.100, 000/25,000 gall; liquid skim,
Br.300, 000/75,000 gall.)

3. Estimated Net Realizable Value (NRV) Method

28
  In many cases, products are processed beyond the splitoff in order to bring
them to a marketable form or to increase their value above their selling
price at the splitoff point.
 The estimated net realizable value is typically used in preference to the
sales value at splitoff point method only when market selling prices for
one or more products at the splitoff point are available.

Eample2: Assume the same situation as in Example 1 except that both cream and
liquid skim can be processed further:
 Cream Butter cream; 25,000 gallons of cream are further processed to yield
20,000 gallons of butter cream at additional processing (separable) costs of
Br.280, 000. Butter cream, sold for Br.25 per gallon, is used in the manufacture of
butter-based products.
 Liquid skim Condensed Milk; 75,000 gallons of liquid skim are further
processed to yield 50,000 gallons of condensed milk at additional processing costs
of Br.520,000. Condensed milk is sold for Br.22 per gallon.
 Sales during the accounting period were 12,000 gallons of butter cream and
45,000 gallons of condensed milk.

Beginning Inventory Ending Inventory

Raw milk 0 gallons 0 gallons
Cream 0 gallons 0 gallons
Liquid skim 0 gallons 0 gallons
Butter cream 0 gallons 8000 gallons
Condensed milk 0 gallons 5,000 gallons

The estimated NRV method allocates joint costs to joint products on the basis of the
relative estimated NRV (expected final sales value in the ordinary course of business
minus the expected separable costs) of the total production of these products during the
accounting period. Joint costs would be allocated as follows:

Butter Condensed Total

Cream Milk
1. Expected final sales value of production
(Butter cream, 20000gall.*Br.25; condensed Br.500, 000 Br.1, 100,000 Br.1, 600,000
Milk, 50,000gall*Br.22)
2. Deduct expected separable costs to
Complete and sell Br.280, 000 Br.520, 000 800,000
3. Estimated NRV at splitofff point Br.220, 000 Br.580, 000 Br. 800,000
75,000gall/100,000gall)
4. Weighting (220,000/800,000; 580,000/
800,000) 0.275 0.725
5. Joint costs allocated (butter cream, 0.275*
400,000; condensed milk, 0.725*400,000) Br.110, 000 Br.290, 000 Br.400, 000
6. Production cost per gallon (butter cream,
[110, 000+280,000]/20,000 gall; condensed
Milk[290,000+520,000]/50,000gall) Br.19.50 Br.16.20

29
4. Constant Gross-Margin Percentage NRV Method
 Allocates joint costs to joint products in such a way that the overall gross
margin percentage is identical for the individual products. This method
requires three steps:
Step 1: Compute the overall gross-margin percentage.
Step 2: Use the overall gross margin percentage and deduct the gross margin from
the final sales values to obtain the total costs that each product will bear
Step 3: Deduct the expected separable costs from the total costs to obtain the
joint-cost allocation.

Step 1:
Expected final sales value of total production during the accounting period
(20,000gall.*Br.25) + (50,000gall*Br.22) Br.1, 600,000
Deduct joint and separable costs (Br.400, 000+Br.280, 000+
Br.520, 000) 1,200,000
Gross Margin Br. 400,000
Gross Margin percentage (400,000/1,600,000) 25%

Step 2:

Butter Condensed Total

Cream Milk
Expected final sales value of production
During the accounting period: (butter
Cream, 20000gall.*Br.25; condensed
Milk, 50,000gall*Br.22) Br.500, 000 Br.1, 100,000 Br.1, 600,000
Deduct gross margin, using overall
Gross margin percentage (25%) 125,000 275,000 400,000
Cost of Goods Sold 375,000 825,000 1,200,000

Step 3:
Deduct separable costs to complete and sell 280,000 520,000 800,000
Joint costs allocated Br.95, 000 Br.305, 000 Br.400, 000

Accounting for Byproducts

 Joint production process may yield not only joint and main products but
byproducts as well. Although byproducts have much lower sales value than do
joint or main products, the presence of byproducts can affect the allocation of
joint costs.

Example 3: The Meatworks Group processes meat from slaughterhouses. One of its
departments cuts lamb shoulders and generates two products:

30
 Shoulder meat (the main product) – sold for Br.60 per pack.
Hock meat (the byproduct) - sold for Br.4 per pack.
Both products are sold at splitoff point without further processing. Data (number of
packs) for this department in July 2001 are as follows:
Production Sales Big. Inv. End.Inv.
Shoulder meat 500 400 0 100
Hock Meat 100 30 0 70
The joint manufacturing costs of these products in July 2001 were Br.25, 000
(comprising, Br.15, 000 for direct materials and Br.10,000 for conversion costs).

Method A: Byproducts Recognized at the Time Production is Completed

 This method recognizes the byproduct in the financial statements-the 100

packs of hock meat-in the month it is produced (July 2001). The estimated net
realizable value from the byproduct produced is offset against the costs of the
main (or joint) products. The following journal entries illustrate this method:

1. Work in process 15,000

Account Payable 15,000
(To record direct materials purchased and used in production during July)

2. Work-in Process 10,000

Various Accounts 10,000
(To record conversion costs in the production process during July; examples include
energy, manuf.supplies, all Manu. labor, and plant maintenance)

3. Byproduct Inventory-Hock Meat (100*Br.4) 400

Finished Goods –Shoulder Meat (Br.25, 000-400) 24,600
Work-in Process (Br.15, 000+10,000) 25,000
(To record cost of goods completed during July)

4a. Cost of Goods Sold [(400/500)*24,600 19,680

Finished Goods-Shoulder Meat 19,680
(To record cost of the main products sold during July)

b. Cash (Account Receivable) 400*Br.60 24,000

Revenues –Shoulder Meat 24,000
(To record the sales of the main product during July)

5. Cash (Account Receivable) 30*Br.4 120

Byproduct Inventory- Hock Meat 120
(To record the sales of the byproduct during July)

This method reports the byproduct inventories of hock meat in the balance sheet at
their Br.4/pack selling price [(100-30)*Br.4 = Br.280].

31
 Method B: Byproducts Recognized at Time of Sale
 This method makes no journal entries until sale of the byproduct occurs.
Revenues of the byproducts are reported as a revenue item in the income
statement at the time of sale.
In the Meatworks Group example, byproduct revenues in July 2001 would be Br.120
(30*Br.4) because only 30 packs of the hock meat are sold in
July (of the 100 packs produced). The journal entries would be:

1 and 2: Same as for Method A.

3. Finished Goods-Shoulder Meat 25,000
Work-in Process 25,000
(To record cost of goods completed during July)

4a. Cost of Goods Sold [(400/500)*Br.25, 000 20,000

Finished Goods-Shoulder Meat 20,000
(To record cost of the main products sold during July)

4b. Same as for Method A

5. Cash (Account Receivable) 120

Revenues- Hock Meat 120
To record the sales of the byproduct during July)

Method B is rationalized in practice primarily on grounds that the dollar amounts of

byproducts are immaterial. However, this method permits managers to “manage”
reported earnings by timing when they sell byproducts.

III. Allocating Common Costs

A common cost is a cost of operating a facility, activity, or like cost object that is shared
by two or more users.

32
Consider Ayele, a senior student in Addis Ababa University who has been invited to an
interview with an employer in Mekele. The round trip Addis-Mekele airfare costs
Br.1, 200. A week prior to leaving Ayele is also invited to an interview with an employer
in Dessie. The Addis-Dessiee round trip airfare costs Br. 800. Ayele decided to combine
the two recurring trips into an Addis-Mekele-Dessie trip that will cost $1,500 in airfare.
The Br1, 500 is a common cost that benefits both prospective employers.
Two methods of allocating this common cost are:

1. Stand-Alone Cost-Allocation Method

This method uses information pertaining to each user of a cost object as a separate
entity to determine the cost-allocation weights.
For the common cost $1,500, information about the separate (stand alone) round-
trip airfares ($1200, and $800) is used to determine the allocation weights.

Mkele employer: $1,200 * 1,500 = 0.60*1,500= $900

$1,200 + $ 800

Dessie employer: $800 * 1,500 = 0.4 * 1,500 = $600

$800 + $1,200

Advantage: Fairness occurs because each employer bears a proportionate share of total
costs in relation to their individual stand-alone costs.

2. Incremental Cost Allocation Method

 This method ranks the individual users of a cost object and then uses this
ranking to allocate costs among those users.
 The first ranked user of the cost object is termed the primary user. The
second ranked user is termed the incremental party and is allocated the
additional cost that arises from there being two users instead of only the
primary user.
Assume in the example the Mekele fight is viewed as the primary party. Ayele’s
rational is that he had already committed to go to Mekele before accepting the
invitations to interview in Dessie. The cost allocation would be:

Party Cost Allocated Costs remaining to be

Allocated to other parties

Mekele (primary) $1,200 $300 ($1,500 - $1,200)

Chicago (incremental) 300 0

Had the Dessie employer been chosen as the primary party, the cost allocations
would have been Dessie $800 and Mekele $700(1500-800).

33
 Under the incremental method, the primary party typically receives the highest
allocation of the common costs. Most users in common cost situations propose
themselves as the incremental party.

Exercise 1:
Computer Horizon budgets the following amounts for it’s to central corporate support
departments (legal and personnel) in supporting each other and the two manufacturing
divisions- the Laptop Division (LTD) and the Work Station Division (WSD):

Budgeted Capacity
To be supplied by Legal Personnel LTD WSD Total
Legal (hours) - 250 1,500 750 2,500
Percentages - 10% 60% 30% 100%
Personnel (hours) 2,500 - 22,500 25,000 50,000
Percentages 5% - 45% 50% 100%

Details on actual usage are as follows:

Actual usage by
To be supplied by Legal Personnel LTD WSD Total
Legal (hours) - 400 400 1,200 2,000
Percentages - 20% 20% 60% 100%
Personnel (hours) 2,000 - 26,600 11,400 40,000
Percentages 5% - 66.5% 28.5% 100%

Total costs were:

Legal Personnel
Fixed $360,000 $475,000
Variable $200,000 $600,000
Fixed costs are allocated on the basis of budgeted capacity. Variable costs are allocated
on the basis of actual usage.

Required: What amount of support department costs for legal and personnel will be
allocated LTD and WSD using:
a. The Direct Method
b. The Step-Down Method (allocating the Legal Department First).
c. The Reciprocal Method

Exercise 2:

Phoenix consulting provides outsourcing services and advice to both government and
corporate clients. For costing purposes Phoenix classifies its departments into two
support departments (Administrative/Human Resources and Information Systems) and

34
two operating departments (Government Consulting and Corporate Consulting). For the
first quarter of 2000, Phoenix incurs the following costs in its four departments:

Administrative/Human Resource (A/H) $600,000

Information Systems (IS) $2,400,000
Government Clients (GOVT) $8,756,000
Corporate Clients (CORP) $12,452,000
The actual level of support relations among the four departments for the first quarter of
2000 was:
Used by
Supplied by A/H IS GOVT CORP
A/HR - 25% 40% 35%
IS 10% - 30% 60%
The Administrative/Human Resources support percentages are based on headcount. The
Information Systems support percentages are based on actual computer times used.

Required:
Allocate the two support department’s costs to the two operating departments using the
following methods:
1. Direct Method
2. Step-down method (allocate A/H first)
3. Step-down method (allocate IS first)
4. Reciprocal Method.

35