Upstream and downstream costs are often interdependent: eg. R+D and customer service.

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1 CHAPTER 14. PERIOD COST APPLICATION Support department cost allocation is treated separately in part because most period costs are excluded from inventoriable costs by accounting standards. But prices of the finished output must recover all manufacturing and non-manufacturing costs for corporation to remain profitable. Task of the management is to select the best method of cost assignment that most accurately includes the value added. THE RELEVANCE CRITERION Management team must select an observable and countable input to signal different levels of value added. The goal is to allocate period costs of non manufacturing activities proportional to the different levels of benefit provided to each of the users. Upstream and downstream costs are often interdependent: eg. R+D and customer service. If outputs are homogenous, simple average is appropriate, if not homogenous, then runs the risk of inadvertent over and under costing and pricing decisions Discipline of the market: consumers rule when competition is intense. Product bundle: combination of two or more different products, tow or more different services or products and services combined. Careful costing is needed, benefit are: - More accurate full product pricing secures market share - Improve the budgeting process signals entry and exit - Feedback in the form of periodic variance helps regain control - Understand which products are profitable, which are not Relevance: Managers need to allocate non manufacturing cost /period cost in the best possible method so as to generate quality information that gives better control and helps in decision making. 4 possible decisions requiring appropriate allocation of period costs are to: - Provide information for economic decisions - Motivate managers and employees - Justify either costs or reimbursement internally or externally - Measure GAAP compliant income and assets for reports to external parties. For economic purposes: include cost from all business function For motivation purpose: include costs from more than one business function Important notes: - Consider cost benefit analysis of changing the costing system - Time, aggravation and money required

2 Justification of relevance Gives validity and relevance. Many ways of justifications for decisions about the design of cost system: - Causality: direct cause effect relationship between driver and quantities consumed ( direct cost) - Benefit received: internal users of upstream / downstream services are the beneficiaries. Allocation should be based on unequal benefits received by each distinct product a. One product: complication in using average period cost allocation rate when support cost pools are made up of variable and fixed cost b. Multiple products: average cost allocation rate would over cost or under cost products and company shall lose out on profitability - Fairness: equality when parties believe in the system in good faith-> fairness-> simple average - Ability to bear: cost depends on various stakeholders agreement about the fairness. Bundle can be highly profitable when the loss leader is sold based on a variable costing policy ( not going below the total variable cost) DECIDING BETWEEN SINGLE AND DUAL RATE COST METHODS 1. Identify the problem: Single rate method: company uses average cost allocation rate to allocate its non manufacturing cost pools. Dual rate method: fixed and variable cost contributors to the cost pool are allocated based on different cost drivers. 2. Gather relevant information 3. Make predictions about the future: Standard/budget method: based on budgeted use as the quantity of the cost driver and budgeted cost driver rates under the single rate method Under dual rate: fixed cost pools are separated from the variable 4. Decide on and implement on alternative: Small business: easy to follow dual rate method with use of excel spreadsheet Large corporation: easily acquire or apply software to accommodate any. Problem with single rate - Check master budget Q/ Practical Q: customers will not pay for poor capacity utilization policies. Small cost discrepancies in the budget can result in significant unrecoverable amount. - Option of outsourcing Dual rate method: - Incentive for honest capacity use estimates by its managers - Informs when there is excess capacity and opportunity cost 5. Implement the decision and evaluate performance ANALYSIS OF FAVOURABLE AND UNFAVOURABLE EFFICIENCY VARIANCES Pg. 565 (9) Under single rate costing system, feedback is informative and helps with managers performance review

3 Disadvantage is that there may be conflict between the managers of different department as costs are applied based on actual use and the unitized rate adjusted, transforms what should be independent to an interdependent measure. - For motivation and reimbursement, the feedback from variance analyses should distinguish between controllable and uncontrollable costs. - Capacity cannot be altered in the short run uncontrollable, variable cost- controllable - Non manufacturing overhead that has been dedicated asymmetrically to product development, and recovery of this investment should be tracked. Manufacturing overhead cost allocation methods are irrelevant Cost assignment should take into GAAP rules and for purposes of contract reimbursement., to avoid ambiguity in defining reimbursable costs and expensive litigation. For internal reporting purposes, the cost assignment that best motivates employees may conflict with the highest quality of information for use in economic decisions. GAAP usually requires the exclusion of all non-manufacturing costs from inventoriable costs. For external reporting purposes, all non-manufacturing overhead is expensed in the period in which it occurs and does not accumulate in any inventory Customers would not pay for period cost / non value added cost. DECIDING AMONG DIRECT, STEP-DOWN AND RECIPROCAL COST ALLOCATION METHODS Relevance: Period cost application methods selected would differ from a decentralized structure. Since in centralized corporate structures, most facilities sustaining activities are undertaken at corporate headquarters. Direct method: - Simple and intuitive - Readily explained and inexpensive to implement because of little training needed - Any service rendered by one support division to another support division is ignored - Straight forward average costing method: Cost driver shall reduce ( since now the cost driver is less the ignored inter-department transfers Step down method: - Step allocation method/ sequential method - Recognizes cost of services provided by one support division to the other before allocating the remaining service cost pool to the core divisions - Does not recognize the cost of services provided by each cost pool to the other - Two options of ranking:

4 Highest percentage of service provided to other and then the others ( whichever one has a higher allocated %, is first allocated first and the others.) Or, highest cost to lowest cost of services provided. Reciprocal method- linear equation, solver and matrix algebra Adjusts budgeted costs to explicitly include costs of mutual services rendered among support areas in each other s cost pools. The result is a budgeted complete reciprocated cost pool for each support services division. ( also called artificial cost). Drawback: becomes a problem when dealing with more than two support services and two core production divisions. LINEAR EQUATION METHOD: 1. Express support division costs and reciprocal relationships in linear equation form. 2. Solve for the values. 3. Apply the complete artificial costs of each support division to all other divisions on the basis of the usage proportions. Reciprocal method: economically plausible, treats all support division costs equally Step down method results in highest cost reimbursement Reasons why reciprocal method is not adopted:; - Difficult to understand - Numbers obtained by using reciprocal method differ little in some cases from those obtained by using the direct- or step down method. ALLOCATING COMMON COSTS A common cost is a cost of operating a facility, operation, activity, or like cost object that is shared by two or more users. Two ways of allocating common cost: Stand-alone cost allocation method: Uses information pertaining to each cost object as a separate operating entity to determine the cost allocation weights. Pros: equity/fairness rationale proportionate share of total cost Incremental cost allocation method: Ranks the individual cost objects and then uses this ranking to allocate costs among those cost objects. The first ranked cost object is termed primary party and is allocated costs up to its cost as a stand- alone entity.

5 Second ranked cost object: incremental party and is allocated the additional cost that arises from there being two users instead of only the primary user. - Most users place themelves as incremental party/ newly formed organization- so as to bear lower cost. - Chosen method must be acceptable to parties. Justifying reimbursement costs: Require cost accounting: Contracts : dispute arise from cost allocation, mitigated by rules of game explicitly written in the contract- definition of cost items allowed, permissible cost allocation bases, variances handled. Contracting: Two approach to reimburse costs as determined by a contract: - Contractor is paid a set price without analysis of actual contract cost data used in competitive bidding, established catalogue prices - The contractor is paid after analysis of actual contract cost data.( cost + set fee) Fairness of pricing: Competitive bidding is rare since no contractor is willing to assume all the risk. So govt intervenes and assumes major share of risk by negotiating contracts by using cost as substitute for selling prices as ordinarily set by suppliers in open market. - Key: reasonable/ fair/ allowable/ unallowable. - Allowable cost are cost that contract parties agree to include in the costs to be reimbursed.