Separable Cost Reduction in Cost Accounting - dummies

# Separable Cost Reduction in Cost Accounting

In cost accounting, the cost of goods available for sale represents the product’s total costs. Total costs have two components — joint costs and separable costs. When possible, you want to reduce separable costs, but first take a look at your company’s joint costs.

Assume you manufacture leaf blowers. Your two products are heavy-duty blowers and yardwork blowers. The separable costs are \$1,200,000 for the heavy-duty blower and \$912,000 for the yardwork blower. If you know the separable costs and the cost of goods available for sale, you can compute the joint cost allocation. This table shows the process.

Joint Cost Allocation
Heavy-Duty Yardwork Total
Cost of goods available for sale \$1,751,163 \$1,260,837 \$3,012,000
Less separable costs \$1,200,000 \$912,000 \$2,112,000
Equals joint cost allocation \$551,163 \$348,837 \$900,000

Each company division provides the separable costs. So altogether, this table gives you a joint cost allocation.

Now assume that the heavy-duty blower division is able to sharply reduce its separable costs to an amazingly low \$500,000. The first table listed heavy-duty separable costs of \$1,200,000. Consider what now happens to heavy-duty’s joint cost allocation. Take a look at the next table.

Cost Allocation — Less Heavy Duty Separable Costs
Heavy-Duty Yardwork Total
Cost of goods available for sale \$1,751,163 \$1,260,837 \$3,012,000
Less separable costs \$500,000 \$912,000 \$1,412,000
Equals joint cost allocation \$1,251,163 \$348,837 \$1,600,000

Heavy-duty’s joint cost allocation increases to \$1,251,163 (from \$551,163). That doesn’t seem right. The goal is to analyze costs to reduce or eliminate them. If you do, supposedly you increase your profits.

In this case, the heavy-duty division’s reducing separable costs increased its joint cost allocation. There doesn’t seem to be a benefit to operating more efficiently.

Here’s an explanation: The gross margin percentage method (calculated as gross margin ÷ total sales value x 100) locks in total costs as a percentage of sales value. If the gross margin is about 12.5 percent of sales value, it means that costs must be about 87.5 percent of sales value. For heavy-duty, that 87.5 percent total cost number is \$1,751,163. Those costs are either separable or joint costs. If one increases, the other decreases.

The heavy-duty manager may have a problem with this process. The manager works hard (using good old cost accounting) to lower the separable costs. The manager’s “reward” is a higher joint cost allocation. The heavy-duty division has lowered costs but doesn’t get any savings in total costs.

The constant gross margin percentage method clarifies the revenue and profit calculations company-wide. This method eliminates some of the variation between company divisions. Although some managers may complain, each division has the same gross margin percentage. The process makes managing company profit easier.

This is one of those “Here’s why the chief financial officer (CFO) makes the big bucks” moments. As CFO, you explain the gross margin percentage method to the heavy-duty division manager. The goal is to allocate joint costs so that each product maintains the same gross margin percentage of about 12.5 percent. If a division reduces separable costs, it must get a bigger joint cost allocation — otherwise, the gross margin percentage would increase.

Now heavy-duty’s manager should be evaluated based on the successful cost reduction. The manager had a success, and you want to encourage more cost savings. Although the gross margin percentage process requires a bigger joint cost allocation, that must not take away from the manager’s good performance.