Theme 5 - Cost allocation Flashcards
What are some of the reasons for allocating costs?
Some of the reasons for allocating costs are taxes, external financial reporting, third-party reimbursement, and solving the organizational problem.
Describe some ways cost allocations can affect cash-flows.
Cost allocations can affect cash-flows if the firm has contracts tied to reported costs (e.g. defense contractors using cost-plus contracts). Cost allocations can also affect taxes and thus cash-flows. For example, allocating costs can affect product costs and thus the amount of cost of goods sold.
How do allocations act as a tax system?
Allocating costs causes an increase in the reported costs of using the resource being allocated. For example, if property taxes are allocated using square footage, then floor space becomes taxed. These cost allocations are like taxes on these resources. Like all taxes on consumption items, the tax discourages use of the item levied with the tax.
Define externality and give an example of one.
Externalities are costs or benefits imposed on other individuals without their participation in the decision-making process and without out compensation for the cost or benefits imposed on them (e.g. air pollution)
What is the difference between a positive and a negative externality?
A negative externality causes others to bear some cost as the result of a decision made that is bend their control. A positive externality causes others to receive some benefit as the result of a decision made that is out of their control.
How are externalitites reduced within a firm?
One way to reduce an externality is to impose a tax on the use of the resource or the decision that creates the externality.
Describe the three cases to consider when determining if a cost allocation is beneficial.
i) Ra, the overhead rate at volume level a, is greater than MCa, the marginal cost at a. Under this condition, the cost allocation overstates the marginal cost of the externality. Therefore, taxing might cause more harm than good.
ii) Rb = MCb. Under this condition, the cost allocation and the marginal cost are equal. In this case the cost allocation perfectly reflects the amount of tax to apply.
iii) Rc < MCc. Under this condition, the cost allocation rate is less than the marginal cost of the externality. Taxing under this condition is better than no tax.
Should common costs be allocated?
If common costs are not allocated, managers have less incentive to invest in the specialized knowledge necessary to determine the optimal level of the common costs Furthermore, if the decision right over the level of the common costs do not reside with a manager and are not allocated back to the manager’s department, the manager will always demand more common costs.
Describe how a non insulating allocation promotes cooperation among managers and encourages mutual monitoring.
A noninsulating allocation method causes the performance measure (e.g. divisional profits) to depend on the performance of another division. If other divisions improve their performance, your division bears fewer allocated costs and hence will show better performance (after receiving allocated costs). Non-insulating allocation methods create incentives for managers to cooperate and mutually monitor each other to protect their interest.
What is the death spiral and how is it prevented?
The death spiral can result whenever transfer prices include fixed costs and users shift away from the internal common resource. This further increases the full cost transfer price, causing further users to reduce their demand. Death spirals can be avoided by using variable cost transfer pricing and cost allocations.
What are some reasons to allocate service department costs, independent of which allocation method is chosen?
i) To tax the users with some positive price that causes them to reduce their consumption from what it would be under a zero price (no allocation).
ii) By allocating the costs, senior management gets information about the tool demand for the service at the allocated costs.
iii) By comparing the internally allocated cost with the external market price of comparable services, senior management is able to assess the operating efficiency of the service department.
iv) Taxing the internal service helps allocate a scarce resource, At a zero price, demand will will almost always exceed supply. In the absence of a price mechanism to allocate department services, senior management will be confronted with complaints to increase the amount of service via larger budgets and must devise non price priority schemes to manage the queue waiting for service.
What is step-down allocation? What are some criticisms of this allocation method?
Step-down allocation is an allocation method that recognizes that service departments use each other’s services. The process begins by choosing one service department and allocating its cost to the remaining services and operating departments. The process is repeated for each of the remaining service departments. A major criticism of the step-down method is that the sequence is arbitrary and large differences in the cost per unit of service across different sequences are possible. The step-down method also ignores the fact that departments earlier in the sequence use service departments later in the sequence.
How do the direct allocation and step-down methods differ?
The direct allocation method ignores service departments using each other’s services in allocating costs. The step-down method allocates service department costs to other service departments later in the sequence.
What are joint costs? How do they differ from common costs?
Joint costs are costs incurred in the production of two or more outputs from the same production process in fixed proportion. Joint products are produced in fixed proportions. Common costs arise in production settings where there can be substitution among outputs. More of one output can be produced by reducing the output of another product.
Joint costs are associated with disassembly processes where a joint input is disassembled into several products. Common costs usually describe assembly processes where numerous inputs including some common resources are assembled to form the output.
Describe some methods for allocating joint costs.
Three common methods to allocate joint costs are:
i) Physical measures
ii) relative sales value method
iii) net realizable value method
The fundamental point to remember when analyzing situations involving joint costs is that any joint cost allocated to final products is meaningless for assessing product-line profitability.
