2012 McGraw-Hill Education (Asia)

Cost Allocation
Chapter 6
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 2
Cost Allocation and Charges for Services
Rendered
Intracompany inside 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



McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 3
Cost Allocation and Charges for Services
Rendered
Intercompany different entities within the same
group

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
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 4
Learning Objective 1
Explain the major reasons for
the need for allocating
nonmanufacturing costs.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 5
Service Department Charges
Operating
Departments
Carry out central
purposes of
organization.
Service
Departments
Do not directly
engage in
operating
activities.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 6
Reasons for Charging Service Department
Costs
To encourage
operating departments
to wisely use service
department resources.
To provide operating
departments with
more complete cost
data for making
decisions.
To help measure the
profitability of
operating
departments.
To create an incentive
for service
departments to
operate efficiently.
Service department costs are charged to operating
departments for a variety of reasons including:
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 7
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



McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 8
$
Transfer Prices
Operating
Departments
Service
Departments
The service department charges
considered can be viewed as a transfer
price that is charged for services
provided by service departments to
operating departments.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 9
Factors To Be Considered For The Cost
Allocation 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 service
provider, for example, use of a cost-plus performance based
award fee approach, to ensure quality delivery of
service/product


2012 McGraw-Hill Education (Asia)
Service Department Charges
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 11
Learning Objective 2
Allocate costs of service
departments to other operating
departments/units using the cost
behavior concept.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 12
Charging Costs by Behavior
Whenever possible,
variable and fixed
service department costs
should be charged
separately.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 13
Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.
Charging Costs by Behavior
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 14
Charge fixed service department costs to
consuming departments in predetermined
lump-sum amounts that are based on the
consuming departments peak-period or long-
run average servicing needs.
Are based on amounts of
capacity each consuming
department requires.
Should not vary from
period to period.
Charging Costs by Behavior
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 15
Should Actual or Budgeted Costs Be
Charged?
Budgeted variable
and fixed service department
costs should be charged to
operating departments.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 16
Sipco has a maintenance department and two operating
departments: Cutting and Assembly. Variable maintenance
costs 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
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 17
Actual hours
Sipco: End of the Year
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 18
Percent of peak-period capacity.
Sipco: End of the Year
Actual hours
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 19
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 of
Peak-Period
Capacity Miles Miles
Hospitals Required Planned Used
Mercy 45% 15,000 16,000
Northside 55% 17,000 17,500
Total 100% 32,000 33,500
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 20
Quick Check
How much ambulance service cost will be
allocated to Mercy Hospital at the end of the
year?
a. $121,200
b. $254,400
c. $139,500
d. $117,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 21
How much ambulance service cost will be
allocated to Mercy Hospital at the end of the
year?
a. $121,200
b. $254,400
c. $139,500
d. $117,000
Quick Check
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 22
Allocating fixed
costs using a variable
allocation base.
Pitfalls in Allocating Fixed Costs
Result
Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 23
Using sales
dollars as an
allocation base.
Pitfalls in Allocating Fixed Costs
Result
Sales of one department
influence the service
department costs
allocated to other
departments.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 24
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.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 25
Autos R Us First-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 department
increases sales by $500,000. Sales in the other departments
are unchanged. Lets allocate the $80,000 service department
cost for the second year given the sales increase.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 26
Autos R Us Second-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, would
you be happy with the increased service department
costs allocated to your department?
2012 McGraw-Hill Education (Asia)
Service Department Allocations
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 28
Operating Departments
An operating department carries out
the central purpose of the organization
The Surgery
Department
at Mount
Sinai
Hospital.
A
Production
Department
at
Mitsubishi.
The
Geography
Department
at the
University of
Washington.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 29
Service Departments
Service departments do not directly
engage in operating activities.
The
Accounting
Department
at Macys.
The Human
Resources
Department
at Walgreens.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 30
Interdepartmental Services
Service
Department
Operating
Department
Costs of the service
department become
overhead costs to
the operating
department
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 31
Allocation Approaches
Direct
Method

Step-Down
Method

Reciprocal
Method

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 32
Reciprocal Services
Service
Department 1
Service
Department 2
When service
departments provide
services to each
other we call them
reciprocal services.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 33
Learning Objective 3
Allocate service
department costs to
operating departments
using the direct method.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 34
Direct Method
Service
Department
(Cafeteria)
Service
Department
(Custodial)
Operating
Department
(Machining)
Operating
Department
(Assembly)
Interactions
between service
departments are
ignored and all
costs are
allocated directly
to operating
departments.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 35
Direct Method An Example
Service Department Allocation Base
Cafeteria Number of employees
Custodial Square feet occupied
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 36
Direct Method An Example
How much of the Cafeteria and Custodial costs
should be allocated to each operating department
using the direct method of cost allocation?
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 37
Direct Method An Example
Allocation base: Number of employees
$360,000
20
20 + 30
= $144,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 38
Direct Method An Example
Allocation base: Number of employees
$360,000
30
20 + 30
= $216,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 39
Direct Method An Example
Allocation base: Square feet occupied
$90,000
25,000
25,000 + 50,000
= $30,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 40
Direct Method An Example
Allocation base: Square feet occupied
50,000
25,000 + 50,000
$90,000 = $60,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 41
Learning Objective 4
To allocate service
department costs to
operating departments
using the step-down
method.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 42
Operating
Department
(Machining)
Operating
Department
(Assembly)
Step-Down Method
Once a service
departments costs
are allocated,
other service
department costs
are not allocated
back to it.
Service
Department
(Cafeteria)
Service
Department
(Custodial)
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 43
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
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 44
Service Department Allocation Base
Cafeteria Number of employees
Custodial Square feet occupied
We will use the same data used
in the direct method example.
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 45
Allocate Cafeteria costs first since
it provides more service than Custodial.
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 46
$360,000
10
10 + 20 + 30
= $60,000
Allocation base: Number of employees
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 47
$360,000
20
10 + 20 + 30
= $120,000
Allocation base: Number of employees
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 48
$360,000
30
10 + 20 + 30
= $180,000
Allocation base: Number of employees
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 49
New total = $90,000 original Custodial cost
plus $60,000 allocated from the Cafeteria.
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 50
$150,000
25,000
25,000 + 50,000
= $50,000
Allocation base: Square feet occupied
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 51
$150,000
50,000
25,000 + 50,000
= $100,000
Allocation base: Square feet occupied
Step-Down Method An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 52
Reciprocal Method
Interdepartmental
services are given
full recognition
rather than partial
recognition as with
the step method.
Service
Department
(Cafeteria)
Service
Department
(Custodial)
Operating
Department
(Machining)
Operating
Department
(Assembly)
Because of its mathematical complexity,
the reciprocal method is rarely used.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 53
Quick Check Data
for 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.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 54
Quick Check
How much cost will be allocated from
Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 55
How much cost will be allocated from
Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
Quick Check
$180,000
20
20 + 80
= $36,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 56
Quick Check
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 57
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
Quick Check
$90,000
18
18 + 102
= $13,500
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 58
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.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 59
Quick Check
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 60
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
Quick Check
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 61
End of Chapter 6