Question

1.What is the danger in allocating common fixed costs among products or others segments of an organization?

2.From a decision-making point of view, should joint costs be allocated among joint products

3.What is a relevant cost?

Answer 1

(1) Common fixed costs are the indirect cost incurred on overall organisation basis with out any relation or connection with product or segment. From decision making point of view such cost are treated as sunk cost. That is, all cost incurred or commited by organisation having no connection to decision to be taken. In other words, what ever decision is taken regarding product or segment these common fixed costs are not going to be effected.

Hence allocating the common fixed cost to products and other segments is justfied only for the purpose of determining the product pricing or overhead obsorption requirements. But for decision making purpose requiring analysis of profitability should not allow the practice of allocating common fixed costs as it can lead to wrong decisions being taken by including irrelevant costs into the structure.

(2) When products are truely joint products ( i.e not byproducts) then, joint cost must be allocated to joint products on some reasonalble basis. Even the decision making perspective is not an exception to it. Thus Joint cost being the first cost incurred automatically for all joint products becomes relevant cost for determining profitability of products.

However in situation requiring decision on Further processing, joint cost already allocated becomes irrelevant cost. Because, here for deciding on further processing, we consider the incremental revenue and incremental cost ( i.e other than joint cost)

Hence answer to the given question depends on type of decision involved.

(3) Relevant cost : All costs that are involved or likely to be incurred only when a decison is taken becomes relevant cost. For example, for making further 1000 units we need additional material, labor and variable overhead but not the fixed cost. In such a case materials, labor and variable cost becomes relevant costs and fixed cost is irrelevant cost for decision making.