CHAPTER 17

ALLOCATION OF SUPPORT ACTIVITY COSTS AND JOINT COSTS

SERVICE DEPARTMENT COST ALLOCATION: A GENERAL OVERVIEW

A service department is a unit in an organization that is not involved

directly in producing the organization’s goods or services. However, a service
department does provide a service that enables the organization’s production process
to take place. Production departments, on the other hand, are units that are directly
involved in producing the organization’s goods and services. An example of a service
department in a bank would be the computer department or the human resources
department. An example of a “production” department in a bank would be the
consumer loan department.

METHODE OF SERVICE DEPARTMENT COST ALLOCATION.

A. Direct method

Under the direct method of service department cost allocation, all service
department costs are allocated directly to the production departments, and
none of these costs are allocated to other service departments.

B. Step-down method

Under the step-down method, a sequence is first established for allocation of

service department costs. Then the costs incurred in the first service
department in the sequence are allocated among all other departments that use
that service department’s services, including other service departments. The
method proceeds in a similar fashion through the sequence of service
departments.

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 C. Reciprocal-services method (appendix)

Under the reciprocal-services method, a system of simultaneous equations is

established to reflect the reciprocal provision of services among service
departments. Then all of the service departments’ costs are allocated among
all of the departments that use the various service departments’ output of
services. The reciprocal-services method of service department cost allocation
is the only method that fully accounts for the reciprocal provision of services
among departments.

DUAL-COST ALLOCATION

The problem illustrated in the preceding section can be resolved by allocating

fixed and variable costs separately. This approach, called dual cost allocation ,
works with either the direct method or the step-down method of allocation.
Under dual cost allocation, variable costs are allocated on the basis of short-
run usage of the service department’s output; fixed costs are allocated on the
basis of long-run average usage of the service department’s output. The
rationale for this approach is that fixed costs are capacity producing costs.
When service departments are established, their size and scale usually are
determined by the projected long-run needs of the using departments.

Allocate Budgeted Costs

When service department costs are allocated to production departments, such

as the direct patient- care departments of Riverside Clinic, budgeted service
department costs should be used. If actual costs are allocated instead, any
operating inefficiencies in the service departments are passed along to the
using departments. This reduces the incentive for service department

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 managers to control the costs in their departments. The proper approach is as
follows:
1. Compare budgeted and actual service department costs and compute any
variances.
2. Use these variances to help control costs in the service departments.
3. Close out the service department cost variances against the period’s
income.
4. Allocate the service departments’ budgeted costs to the departments that
directly produce goods or services

TODAY’S ADVANCED MANUFACTURING ENVIRONMENT

In traditional manufacturing environments, service department costs
are allocated to production departments to ensure that all manufacturing costs
are assigned to products. For example, the costs incurred in a machine-
maintenance department typically are allocated to the other service
departments and the production departments that use maintenance services.
Service department cost allocation continues to be used in the new
manufacturing environment, characterized by JIT inventory management and
CIM systems. However, the extent of such allocations is diminished in
advanced manufacturing systems, because more costs are directly traceable to
product lines. In a flexible manufacturing system, almost all operations are
performed in the FMS cell. Even machine maintenance is done largely by the
FMS cell operators rather than a separate maintenance department. Inspection
often is performed by FMS cell operators, eliminating the need for a separate
inspection department. In short, as more and more costs become directly
traceable to products, the need for allocation of indirect costs declines.
Under two-stage allocation with departmental overhead rates, costs
first are distributed to departments; then they are allocated from service
departments to production departments. Finally, they are assigned from
production departments to products or services. Departments play a key role

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 as intermediate cost objects under this approach. In an activity-based costing
(ABC) system, on the other hand, the key role is played by activities, not
departments. First, the costs of various activities are assigned to activity-cost
pools; then these costs are assigned to products or services. The breakdown of
costs by activity in an ABC system is much finer then a breakdown by
departments. The ABC approach generally will provide a much more accurate
cost for each of the organization’s products or services.

JOINT PRODUCT COST ALOOCATION AND SPLIT- OFF POINT

A joint production process results in two or more products, which
are termed joint products . The cost of the input and the joint production
process is called a joint product cost. The point in the production process
where the individual products become separately identifiable is called the
split-off point .

A. Joint products and the split-off point

Under the physical-units method of joint cost allocation, joint production
costs are allocated among the joint products in proportion to a physical
characteristic of those products, such as weight or volume.

B. Physical-units method
Under the physical-units method of joint cost allocation, joint production
costs are allocated among the joint products in proportion to a physical
characteristic of those products, such as weight or volume.

C. Relative-sales-value method
Under the relative-sales-value method of joint cost allocation, joint
production costs are allocated to the joint products in proportion to their
sales value at the split-off point.

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D. Net-realizable-value method

The net realizable value of a joint product is equal to its ultimate sales
value minus the separable costs incurred between the split-off point and
the product’s final form. Under the net-realizable-value method of joint
cost allocation, joint production costs are allocated among the joint
products in proportion to their net realizable values.

E. By-product:
A joint product with very little value relative to the other joint products.