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2012 McGraw-Hill Education (Asia)

Cost Allocation

Chapter 6

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McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 2

Cost Allocation and Charges for ServicesRendered

Intracompanyinside the same entity

This chapter will cover

reasons for establishment of an internal service

charging system or to have an cost allocation system

techniques and principles of allocation to be used

allocation of service department costs to operating

departments using the direct and step-down methods

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Cost Allocation and Charges for ServicesRendered

Intercompanydifferent entities within the samegroup

Transfer pricing

may help groups tax planning may be monitored and scrutinized by tax authorities

and other interested regulating bodies/agents.

needs to be seen as an arms length transaction

Will be covered in Chapter 13 Appendix A

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Learning Objective 1

Explain the major reasons forthe need for allocating

nonmanufacturing costs.

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Service Department Charges

OperatingDepartments

Carry out central

purposes oforganization.

ServiceDepartments

Do not directly

engage inoperatingactivities.

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Reasons for Charging Service DepartmentCosts

To encourage

operating departmentsto wisely use servicedepartment resources.

To provide operatingdepartments with

more complete costdata for making

decisions.

To help measure theprofitability of

operatingdepartments.

To create an incentivefor service

departments tooperate efficiently.

Service department costs are charged to operatingdepartments for a variety of reasons including:

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Management Needs

Need to understand the full cost of providing a productor service (including supporting costs) to make betterdecision.

Ensuring competitive costing and pricing

Assessment of risk and potential success of theproduct/service

Financial and operational forecasts and planning

Motivating performance evaluation and reward

system Communicating to employees about the

importance of recovering all indirect costs

Encouraging efficient and effective use ofresources

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$

Transfer Prices

OperatingDepartments

ServiceDepartments

The service department chargesconsidered can be viewed as a transfer

price that is charged for servicesprovided by service departments to

operating departments.

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Factors To Be Considered For The CostAllocation Approach Cost-benefit Evaluation

Including tangible and intangible costs and benefits

Cause and effect

Absorption of cost based on who causes it

Benefit Received Absorption of cost based on the ultimate benefactor

Ability to Bear

Absorption of cost based on who/which product has the

ability and profit margin to bear the cost Fairness or Equity

Ensuring fair game and decent profit to motive serviceprovider, for example, use of a cost-plus performance based

award fee approach, to ensure quality delivery ofservice/product

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Service Department Charges

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Allocate costs of servicedepartments to other operating

departments/units using the costbehavior concept.

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Charging Costs by Behavior

Whenever possible,variable and fixed

service department costsshould be charged

separately.

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Variable servicedepartment costs should be

charged to consuming departmentsaccording to whatever activitycauses the incurrence

of the cost.


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Charge fixedservice department costs toconsuming departments in predeterminedlump-sum amounts that are based on the

consuming departments peak-period or long-run average servicing needs.

Are based on amounts ofcapacity each consuming

department requires.

Should not vary fromperiod to period.


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Should Actual or Budgeted Costs BeCharged?

Budgeted variable

and fixed service departmentcosts should be charged to

operating departments.

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Sipco has a maintenance department and two operatingdepartments: Cutting and Assembly. Variable maintenancecosts are budgeted at $0.60 per machine hour. Fixed

maintenance costs are budgeted at $200,000 per year.Data relating to the current year are:

Allocate maintenance costs to the two operating departments.

Sipco: An Example

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Actual hours

Sipco: End of the Year

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Percent of peak-period capacity.

Sipco: End of the Year

Actual hours

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Quick Check

Foster City has an ambulance service that is usedby the two public hospitals in the city. Variable

ambulance costs are budgeted at $4.20 per mile.Fixed ambulance costs are budgeted at $120,000

per year. Data relating to the current year are:

Percent of

Peak-Period

Capacity Miles Miles

Hospitals Required Planned UsedMercy 45% 15,000 16,000

Northside 55% 17,000 17,500

Total 100% 32,000 33,500

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Quick Check

How much ambulance service cost will beallocated to Mercy Hospital at the endof theyear?

a. $121,200b. $254,400

c. $139,500

d. $117,000

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How much ambulance service cost will beallocated to Mercy Hospital at the endof theyear?

a. $121,200b. $254,400

c. $139,500

d. $117,000

Quick Check

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Allocating fixedcosts using a variable

allocation base.

Pitfalls in Allocating Fixed Costs

Result

Fixed costsallocated to onedepartment are

heavily influenced bywhat happens in

other departments.

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Using salesdollars as an

allocation base.

Pitfalls in Allocating Fixed Costs

Result

Sales of one departmentinfluence the service

department costsallocated to other

departments.

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Autos R UsAn Example

Autos R Us has one service department and threesales departments, New Cars, Used Cars, and CarParts. The service department costs total $80,000

for both years in the example.

Contrary to good practice, Autos R Us allocates theservice department costs based on sales.

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Autos R UsFirst-year Allocation

New Used Parts Total

Sales by department 1,500,000$ 900,000$ 600,000$ 3,000,000$

Percentage of total sales 50% 30% 20% 100%

Allocation of service

department costs 40,000$ 24,000$ 16,000$ 80,000$

Departments

$1,500,000 $3,000,000 50% of $80,000

In the next year, the manager of the New Cars departmentincreases sales by $500,000. Sales in the other departmentsare unchanged. Lets allocate the $80,000 service department

cost for the second year given the sales increase.

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Autos R UsSecond-year Allocation

New Used Parts Total

Sales by department 2,000,000$ 900,000$ 600,000$ 3,500,000$

Percentage of total sales 57% 26% 17% 100%

Allocation of service department costs 45,714$ 20,571$ 13,714$ 80,000$

Departments

$2,000,000 $3,500,000 57% of $80,000

If you were the manager of the New Cars department, wouldyou be happy with the increased service department

costs allocated to your department?

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2012 McGraw-Hill Education (Asia)

Service DepartmentAllocations

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Operating Departments

Anoperating department carries outthe central purpose of the organization

The SurgeryDepartment

at Mount

SinaiHospital.

AProductionDepartment

atMitsubishi.

TheGeographyDepartment

at the

University ofWashington.

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Service Departments

Service departments do not directlyengage in operating activities.

TheAccountingDepartment

at Macys.

The HumanResourcesDepartment

at Walgreens.

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Interdepartmental Services

ServiceDepartment

OperatingDepartment

Costs of the servicedepartment becomeoverhead costs to

the operatingdepartment

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Allocation Approaches

DirectMethod

Step-DownMethod

ReciprocalMethod

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Reciprocal Services

ServiceDepartment 1

ServiceDepartment 2

When servicedepartments provide

services to eachother we call them

reciprocal services.

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Allocate servicedepartment costs to

operating departmentsusing the direct method.

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Direct Method

ServiceDepartment(Cafeteria)

Service

Department(Custodial)

OperatingDepartment(Machining)

Operating

Department(Assembly)

Interactionsbetween servicedepartments are

ignored and allcosts are

allocated directlyto operatingdepartments.

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Direct MethodAn Example

Service Department Allocation Base

Cafeteria Number of employees

Custodial Square feet occupied

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How much of the Cafeteria and Custodial costsshould be allocated to each operating department

using the direct method of cost allocation?

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Allocation base: Number of employees

$360,000 2020 + 30

= $144,000

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$360,000 3020 + 30

= $216,000

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Allocation base: Square feet occupied

$90,000 25,00025,000 + 50,000

= $30,000

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50,00025,000 + 50,000

$90,000 = $60,000

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To allocate servicedepartment costs to

operating departments

using the step-downmethod.

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Operating

Department(Assembly)

Step-Down Method

Once a servicedepartments costs

are allocated,other service

department costsare not allocated

back to it.


Service

Department(Custodial)

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There are three key points to understand regarding

the step-down method:In both the direct and step-down methods, any

amount of the allocation base attributable to the

service department whose cost is being allocated isalways ignored.

Any amount of the allocation base that isattributable to a service department whose cost has

already been allocated is ignored. Each service department assigns its own costs to

operating departments plus the costs that havebeen allocated to it from other service departments.

Step-Down Method

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Service Department Allocation Base

Cafeteria Number of employees

Custodial Square feet occupied

We will use the same data usedin the direct method example.

Step-Down MethodAn Example

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Allocate Cafeteria costs first sinceit provides more service than Custodial.


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$360,000 1010 + 20 + 30

= $60,000



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$360,000 2010 + 20 + 30

= $120,000



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$360,000 3010 + 20 + 30

= $180,000



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New total = $90,000 original Custodial costplus $60,000 allocated from the Cafeteria.


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$150,000 25,00025,000 + 50,000

= $50,000



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$150,000 50,00025,000 + 50,000

= $100,000



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Reciprocal Method

Interdepartmentalservices are given

full recognition

rather than partialrecognition as withthe step method.


ServiceDepartment

(Custodial)


OperatingDepartment

(Assembly)

Because of its mathematical complexity,the reciprocal method is rarely used.

Quick Check Data

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Quick Check Datafor Direct and Step-Down Methods

Allocation bases:

Business school administration costs (ADMIN):Number of employees

Business Administration computer services (BACS):Number of personal computers

The direct method of allocation is used.

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Quick Check

How much cost will be allocated fromAdministration to Accounting?

a. $ 36,000

b. $144,000c. $180,000

d. $ 27,000

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How much cost will be allocated fromAdministration to Accounting?

a. $ 36,000

b. $144,000c. $180,000

d. $ 27,000

Quick Check

$180,000 20

20 + 80= $36,000

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Quick Check

How much total cost will be allocated fromADMIN and BACS combined to theAccounting Department?

a. $ 52,500b. $135,000

c. $270,000

d. $ 49,500

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a. $ 52,500b. $135,000

c. $270,000

d. $ 49,500

Quick Check

$90,000 18

18 + 102= $13,500

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Quick Check Data

Allocation bases:

Business school administration costs (ADMIN):Number of employees

Business administration computer services (BACS):Number of personal computers

The step method of allocation is used.

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Quick Check


a. $35,250

b. $49,072

c. $18,000

d. $26,333

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a. $35,250

b. $49,072

c. $18,000

d. $26,333

Quick Check

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End of Chapter 6

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