© 2012 McGraw-Hill Education (Asia) Cost Allocation Chapter 6

© 2012 McGraw-Hill Education (Asia)

Cost Allocation

Chapter 6

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

Cost Allocation and Charges for Services Rendered

Intracompany – inside the same entity

This chapter will coverreasons 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


Cost Allocation and Charges for Services Rendered Intercompany – different entities within the same

group

Transfer pricing may help group’s tax planning may be monitored and scrutinized by tax authorities

and other interested regulating bodies/agents. needs to be seen as an “arm’s length transaction”

Will be covered in Chapter 13 Appendix A


Learning Objective 1

Explain the major reasons for Explain the major reasons for the need for allocating the need for allocating

nonmanufacturing costs.nonmanufacturing costs.


Service Department Charges

Operating Departments

Carry out central purposes of organization.

Service Departments

Do not directly engage in operating activities.


Reasons for Charging Service Department Costs

To encourage operating departments to wisely use service

department resources.

To encourage operating departments to wisely use service

department resources.

To provide operating departments with

more complete cost data for making

decisions.

To provide operating departments with

more complete cost data for making

decisions.

To help measure the profitability of

operating departments.

To help measure the profitability of


To create an incentive for service

departments to operate efficiently.

To create an incentive for service

departments to operate efficiently.

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


Management Needs Need to understand the full cost of providing a

product or service (including supporting costs) to make better decision.

• Ensuring competitive costing and pricing • Assessment of risk and potential success of

the product/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 of

resources • Ensuring long-term sustainability and

competitiveness


$

Transfer Prices

OperatingDepartments

ServiceDepartments

The service department charges considered can be viewed as a transfer

price that is charged for services provided by service departments to operating departments/companies

within the group.

The service department charges considered can be viewed as a transfer

price that is charged for services provided by service departments to operating departments/companies

within the group.


Factors To Be Considered For The Cost Allocation Approach and Intercompany/Interdepartmental charges

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 service provider, for example, use of a cost-plus performance based award fee approach, to ensure quality delivery of service/product


Service Department Charges



Allocate costs of service Allocate costs of service departments to other operating departments to other operating

departments/units using the cost departments/units using the cost behavior concept.behavior concept.


Charging Costs by Behavior

Whenever possible,variable and fixed

service department costsshould be charged

separately.


Variable servicedepartment costs should be

charged to consuming departmentsaccording to whatever activity

causes the incurrence of the cost.



Charge fixed service department costs to consuming departments in predetermined lump-sum amounts that are based on the consuming department’s peak-period or

long-run average servicing needs.

Charge fixed service department costs to consuming departments in predetermined lump-sum amounts that are based on the consuming department’s peak-period or

long-run average servicing needs.

Are based on amounts ofcapacity each consuming

department requires.

Should not vary fromperiod to period.



Should Actual or Budgeted Costs Be Charged?

Budgeted variableand fixed service departmentcosts should be charged to



Sipco has a maintenance department and two operatingdepartments: Cutting and Assembly. Variable maintenance

costs are budgeted at $0.60 per machine hour. Fixedmaintenance 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


Actual hours

Sipco: End of the Year


Percent of peak-period capacity.

Sipco: End of the Year

Actual hours


Quick Check Foster City has an ambulance service that is used

by 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 ofPeak-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


Quick Check

How much ambulance service cost will be allocated to Mercy Hospital at the end of the year?a. $121,200b. $254,400c. $139,500d. $117,000





Quick Check


Allocating fixed costs using a variable

allocation base.

Pitfalls in Allocating Fixed Costs


Using salesdollars as an

allocation base.

Pitfalls in Allocating Fixed Costs

Result

Sales of one departmentinfluence the service

department costsallocated to other

departments.


Autos R Us – An Example

Autos R Us has one service department and three sales departments, New Cars, Used Cars, and Car Parts. The service department costs total $80,000

for both years in the example. Contrary to good practice, Autos R Us allocates the

service department costs based on sales.

Autos R Us has one service department and three sales departments, New Cars, Used Cars, and Car Parts. The service department costs total $80,000

for both years in the example. Contrary to good practice, Autos R Us allocates the

service department costs based on sales.


Autos R Us – First-year Allocation

New Used Parts TotalSales 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 departments

are unchanged. Let’s allocate the $80,000 service departmentcost for the second year given the sales increase.

In the next year, the manager of the New Cars departmentincreases sales by $500,000. Sales in the other departments

are unchanged. Let’s allocate the $80,000 service departmentcost for the second year given the sales increase.


Autos R Us – Second-year Allocation

New Used Parts TotalSales 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?

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

costs allocated to your department?


Service Department Allocations


Operating Departments

An operating department carries out the central purpose of the organization

An operating department carries out the central purpose of the organization

The Surgery Department

at Mount Sinai

Hospital.

The Surgery Department

at Mount Sinai

Hospital.

A Production Department

at Mitsubishi.

A Production Department

at Mitsubishi.

The Geography Department

at the University of Washington.

The Geography Department

at the University of Washington.


Service Departments

Service departments do not directly engage in operating activities.

Service departments do not directly engage in operating activities.

The Accounting Department at Macy’s.

The Accounting Department at Macy’s.

The Human Resources Department

at Walgreens.

The Human Resources Department

at Walgreens.


Interdepartmental Services

ServiceDepartment

OperatingDepartment

Costs of the service department become overhead costs to

the operating department


Allocation Approaches


Reciprocal Services

ServiceDepartment 1

ServiceDepartment 2

When service departments provide

services to each other we call them

reciprocal services.



Allocate service Allocate service department costs to department costs to

operating departments operating departments using the direct method.using the direct method.


Direct Method

Service Department(Cafeteria)

Service Department(Custodial)

Operating Department(Machining)

Operating Department(Assembly)


Direct Method – An Example

Service Department Allocation Base

Cafeteria Number of employeesCustodial Square feet occupied



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

using the direct method of cost allocation?



Allocation base: Number of employees Allocation base: Number of employees



Allocation base: Number of employees

$360,000 ×30

20 + 30= $216,000



Allocation base: Square feet occupied Allocation base: Square feet occupied

$90,000 ×25,000

25,000 + 50,000 = $30,000






To allocate service To allocate service department costs to department costs to

operating departments operating departments using the step-down using the step-down

method.method.




Step-Down Method

Once a servicedepartment’s costs

are allocated, other service

department costsare not allocated

back to it.




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 is

always ignored.

Any amount of the allocation base that is attributable 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 have been allocated to it from other service departments.

Step-Down Method


Service Department Allocation Base

Cafeteria Number of employeesCustodial Square feet occupied

We will use the same data used in the direct method example.

Step-Down Method – An Example


Allocate Cafeteria costs first sinceit provides more service than Custodial.

Allocate Cafeteria costs first sinceit provides more service than Custodial.



$360,000 ×10

10 + 20 + 30= $60,000



Helen Roybark

Slide 101Title: Added "-down" and "- An Example" to match Lecture Notes.


$360,000 ×20

10 + 20 + 30= $120,000




$360,000 ×30

10 + 20 + 30= $180,000




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



$150,000 ×25,000

25,000 + 50,000 = $50,000




$150,000 ×50,000

25,000 + 50,000 = $100,000




Reciprocal Method

Interdepartmentalservices are given

full recognitionrather than partialrecognition as withthe step method.





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

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


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.


Quick Check

How much cost will be allocated from Administration to Accounting?a. $ 36,000b. $144,000c. $180,000d. $ 27,000


How much cost will be allocated from Administration to Accounting?

a. $ 36,000b. $144,000c. $180,000d. $ 27,000

Quick Check

$180,000 ×20

20 + 80= $36,000


Quick Check

How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $ 52,500b. $135,000c. $270,000d. $ 49,500


How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $ 52,500b. $135,000c. $270,000d. $ 49,500

Quick Check


Quick Check Data


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


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

The step method of allocation is used.


Quick Check

How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $35,250b. $49,072c. $18,000d. $26,333


How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $35,250b. $49,072c. $18,000d. $26,333

Quick Check


End of Chapter 6

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© 2012 McGraw-Hill Education (Asia) Cost Allocation Chapter 6