AGENDA

Rationale of allocating service department

AF 3112 costs
MANAGEMENT ACCOUNTING 2 Cost allocation criteria
Single service department cost allocation
Allocation of Multiple service department cost allocation
Service Department Costs

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Service vs. Production Reasons for Allocating

Departments Service Department Costs
Production Service To encourage operating To provide operating
Departments Departments departments to wisely departments with more
use service department complete cost data
resources. for making decisions.
Carry out the Provide support
central purposes that facilitates the To help measure the To create incentive
of an organization. activities of production profitability of operating for service departments
departments. departments. to operate efficiently.

To value inventory for To include all overhead

external financial in the cost base when
reporting purposes. cost-plus pricing is used.
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 Operating Departments Operating Departments
Implications Implications
First Stage Allocations
Service department costs are
Once service department cost Service allocated to operating departments.
allocations are completed, they are Department
included in operating departments’: (Cafeteria) Operating
Department
Service (Machining)
The
Department
Products
(Accounting) Operating
Performance Profitability Overhead rate Department
evaluations determination computations Service (Assembly)
Department
(Personnel)
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Operating Departments
Implications Cost Allocation Criteria
Second Stage Allocations
Operating department overhead costs and Cause and Effect
Service allocated service department costs are l Absorption of cost based on who causes it
applied to products.
Department
(Cafeteria) Benefit Received
Operating
Department l Absorption of cost based on the ultimate benefactor
Service (Machining) Ability to Bear
The
Department
Products l Absorption of cost based on who/which product has
(Accounting) Operating the ability and profit margin to bear the cost
Department
Service (Assembly) Fairness or Equity
Department l Ensuring fair game and decent profit to motive
(Personnel) service provider
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 Examples of Allocation Bases
Service Department
Laundry
Airport Ground Services
Cafeteria
Medical Facilities
Materials Handling
Information Technology
Custodial Services
Cost Accounting
Power
Human Resources
Receiving, Shipping, and Stores
Factory Administration
Maintenance
Single Rate Method Example
Hamish and Barton(H&B) is a
professional accounting firm. The
photocopying department is a service
department with budgeted costs as
follows:
Fixed costs……………… $26,190
Variable costs….. $0.023 per page
Single Service Department
Allocation
Allocation Bases
Pounds of laundry Two basic methods:
Number of flights
Number of meals l Single Rate Method
Cases handled; number of employees;
hours worked
l Allocate service department costs to operating
Hours of service; volume handled departments using a single allocation base.
Number of personal computers;
l No distinction between fixed vs variable costs in the
applications installed
Square footage occupied allocation.
Labor hours; customers served
KWH used; capacity of machines
l Dual Rate Method
Number of employees; training hours l Allocation service department costs to operating
Units handled; number of requisitions; departments using different allocation bases for
space occupied
Total labor hours fixed and variable costs.
Machine hours
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Single Rate Method Example
(cont’d)
! Estimated usage in pages by the three operating
departments is as follows:
§ Audit Department 94,500
§ Tax Department 67,500
§ MAS Department 108,000
§ Total 270,000
Variable cost: 270,000 x $0.023 $ 6,210
Fixed cost 26,190
Total cost for 270,000 pages $32,400
Allocation Rate: ($32,400 ÷ 270,000) = $0.12 per page
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 Single Rate Method Example Single Rate Method Example
(cont’d) (cont’d)
Total Photocopying Department Cost Allocation ! Assume usage in pages by the three operating
Number Charge Total departments is changed as follows:
x =
of Pages per Page Charge
§ Audit Department 94,500
Audit Department 92,000 $0.12 $11,040 § Tax Department 67,500
Tax Department 65,000 0.12 7,800 § MAS Department 53,000
MAS Department 115,000 0.12 13,800 § Total 215,000

Total 272,000 $32,640 Variable cost: 215,000 x $0.023 $ 4,945

Question: How much cost has been incurred by Photocopying Fixed cost 26,190
Department based on the actual usage? Total cost for 215,000 pages $31,135
Answer: $32,446 (=$26,190 + 0.023 x 272,000) New Allocation Rate:
Why does this differ from the total charge above? ($31,135 ÷ 215,000) = $0.145 per page (WHY more?)
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Single Rate Method Example

Single Rate Method
(cont’d)
An external vendor offers MAS department Advantage
photocopying service of $0.1 per page. l Simple to implement
l Should MAS department accept it? l No need to categorize costs into fixed vs. variable
l Yes. Cost savings for MAS department
Problem
l $0.02 / Page ($0.12 – $0.1)
l To allocate fixed costs as variable costs is problematic
l Does this benefit Hamish and Barton(H&B)?
l NO.
l Cost Savings for H&B: $0.023 per Page
l i.e. H&B incur add. costs of $0.077 ($0.1 - $0.023)

What cause(s) such a dilemma?

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 Dual Rate Method
When possible, variable and fixed service
department costs should be allocated separately.
Allocate fixed service department costs to
consuming departments in predetermined lump-
sum amounts that are based on the consuming
departments’ long-run average (or peak) needs.
l Fixed cost allocations are based on amounts of
capacity each consuming department requires
l Fixed cost allocations should not vary from period to
period.
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Dual Rate Method
If variable cost allocations are made at the
end of the year, the budgeted variable
rate should be multiplied by the actual
activity level of each consuming department.
Allocations made at
the end of the year provide
data for performance
evaluation.
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Dual Rate Method
If variable cost allocations are made at the
beginning of the year, the budgeted variable
rate should be multiplied by the budgeted
activity level of each consuming department.
Allocations made
at the beginning of the
year provide data for
pricing, planning and other
decisions.
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Dual Rate Method Example
SimCo has a maintenance department and two production
departments: cutting and assembly.
Variable maintenance costs are budgeted at $0.60 /machine hr.
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.
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 SimCo: Beginning of the Year SimCo: End of the Year

Hours planned Hours used

Percent of peak-period capacity. Percent of peak-period capacity.

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SimCo: Comparison of SimCo: Comparison of

Results Results
Only budgeted variable and fixed service
department costs were allocated to the
two operating departments.

The cost of service department inefficiencies,

contained in the actual costs, should not
be passed along to operating departments.

Fixed cost allocations are the same at the

end and at the beginning because they are
based on capacity instead of usage.
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 Quick Check Quick Check ü
Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable
How much ambulance service cost
ambulance costs are budgeted at $4.20 per mile.
Fixed ambulance costs are budgeted at $120,000 will be allocated to Mercy Hospital at
per year. Data relating to the current year are: the end of the year?
a. $114,000
b. $118,800
Miles Miles c. $110,400
Hospitals Planned Used
Mercy 14,400 16,000 d. $121,200
Northside 17,600 17,500
Total 32,000 33,500
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Multiple Service Departments

Quick Check ü
Cost Allocation
PROBLEM
Under multiple service departments, how do we
How much ambulance service cost allocate costs of service departments?
will be allocated to Mercy Hospital at
the end of the year?
a. $114,000
b. $118,800 Solutions
c. $110,400 Direct Method
d. $121,200 Step Method
Reciprocal Method
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 Direct Method Direct Method Example

Service Operating
Interactions Department Department
between service (Cafeteria) (Machining)
departments are
ignored and all
costs are
allocated directly
to operating Service Operating
departments. Department Department Service Department Allocation Base
(Custodial) (Assembly) Cafeteria Number of employees
Custodial Square feet occupied

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Direct Method Example Direct Method Example

20
$360,000 × = $144,000
20 + 30
30
$360,000 × = $216,000
20 + 30

31
Allocation base: Number of employees 32
 Direct Method Example Step Method
Also known as
l Step-Down Method
l Sequential Allocation Method
Service department Service Operating
costs are allocated
Department Department
to other service
departments first and then
(Cafeteria) (Machining)
to production
departments; usually
25,000
$90,000 × = $30,000 starting with the
25,000 + 50,000 service department
50,000 that serves the Service Operating
$90,000 × = $60,000 Department
25,000 + 50,000 largest number of Department
other service (Custodial) (Assembly)
Allocation base: Square feet occupied 33
departments. 34

Step Method Step Method

Service Operating Service Operating

Department Department Department Department
Once a service (Cafeteria) (Machining) Custodial will (Cafeteria) (Machining)
department’s costs have a new
are allocated, total cost to allocate
other service to production
department costs departments: its
are not allocated own costs plus
back to it. Service Operating those costs Service Operating
Department Department allocated from Department Department
(Custodial) (Assembly) the cafeteria. (Custodial) (Assembly)

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 Step Method Example
We will use the same data used
in the direct method example.
Step Method Example (cont’d)
First, the service department which
provides more service will allocate first.
Criteria:
l Based on dollar volume of service
l Based on % of total service to other service dept
l Cafeteria to Custodial: 16.67% [10/(10+20+30)]
l Custodial to Cafeteria: 6.25% [5/(5+25+50)]

l Thus, allocate Cafeteria costs first

Service Department Allocation Base
Cafeteria Number of employees
Custodial Square feet occupied

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Step Method Example (cont’d) Step Method Example (cont’d)

10
$360,000 × = $60,000
10 + 20 + 30
Allocate Cafeteria costs first since $360,000 ×
20
= $120,000
it provides more service than Custodial. 10 + 20 + 30
30
$360,000 × = $180,000
10 + 20 + 30

39
Allocation base: Number of employees 40
Step Method Example (cont’d) Step Method Example (cont’d)

25,000
New total = $90,000 original Custodial cost $150,000 × = $50,000
25,000 + 50,000
plus $60,000 allocated from the Cafeteria.
50,000
$150,000 × = $100,000
25,000 + 50,000

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Allocation base: Square feet occupied 42

Reciprocal Method Reciprocal Method

Most precise allocation method though
Service Operating more complex.
Department Department
(Cafeteria) (Machining)
Methodology:
Interdepartmental
services are given l Express the support department costs and their
full recognition reciprocal relationships using math equations
rather than partial
recognition as with l Solve the equations to obtain the complete
the step method. Service Operating
reciprocated costs of each support department
Department Department l Allocate the complete reciprocated costs to all
(Custodial) (Assembly) operating and service departments based on their
respective usage percentage
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 Reciprocal Method Example Reciprocal Method Example
Support Departments Producing Departments
(cont’d)
Power Maintenance Grinding Assembly
Direct costs:
M = Direct costs + Share of Power’s costs
Fixed $200,000 $100,000 $ 80,000 $50,000
Variable 50,000 60,000 20,000 10,000 M = $160,000 + 0.2P (Power’s cost equation)
Total $250,000 $160,000 $100,000 $60,000 M = $160,000 + $50,000 + 0.02M
0.98M = $210,000
Proportion of Output Used by Departments
Power Maintenance Grinding Assembly M = $214,286
Allocation ratios:
Power --- 0.20 0.60 0.20
Maintenance 0.10 --- 0.45 0.45
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Reciprocal Method Example Reciprocal Method Example

(cont’d) (cont’d)
Allocated to
Total Cost Grinding Assembly
P = Direct cost + Share of Maintenance’s cost
P = $250,000 + 0.1M (Maintenance cost equation) Power $271,429 $162,857 $ 54,286
Maintenance 214,286 96,429 96,429
P = $250,000 + 0.1($214,286)
Total .60$259,286
x $271,429 .20$150,715
x $271,429
P = $250,000 + $21,429
P = $271,429 .45 x $214,286 .45 x $214,286
There is no need allocating to the support department as
the costs will be netted out with the reciprocated costs.
l E.g. Power à Maintenance = 0.2 x 217,429 = $54,286
l Maintenance costs (un-reciprocated) = 160,000 (given)
l Post-allocation maintenance cost = $54,286 + $160,000 = $214,286
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 Quick Check Data Quick Check ü

How much cost will be allocated from

Administration to Accounting?
a. $ 36,000
The direct method of allocation is used. b. $144,000
Allocation bases: c. $180,000
lBusiness school administration costs (ADMIN): d. $ 27,000
Number of employees
lBusinessAdministration computer services
(BACS): Number of personal computers
49 50

Quick Check ü Quick Check ü

How much cost will be allocated from

Administration to Accounting?
How much total cost will be allocated
a. $ 36,000 from ADMIN and BACS combined to
b. $144,000 the Accounting Department?
c. $180,000 a. $ 52,500
d. $ 27,000 b. $135,000
c. $270,000
20 d. $ 49,500
$180,000 × = $36,000
20 + 80
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 Quick Check ü Quick Check Data

How much total cost will be allocated

from ADMIN and BACS combined to
the Accounting Department?
a. $ 52,500 The step method of allocation is used.
Allocation bases:
b. $135,000
lBusiness school administration costs (ADMIN):
c. $270,000 Number of employees
d. $ 49,500 lBusinessadministration computer services
18 (BACS): Number of personal computers
$90,000 × = $13,500
18 + 102 53 54

Quick Check ü Quick Check ü

How much total cost will be allocated How much total cost will be allocated
from ADMIN and BACS combined to from ADMIN and BACS combined to
the Accounting Department? the Accounting Department?
a. $35,250 a. $35,250
b. $49,072 b. $49,072
c. $49,909 c. $18,000
d. $26,333 d. $26,333

First use dollar volume of services

then
percentage of total service to other service departments 55 56
Using percentage of total service to other service
department.

End of Topic

5
ADMIN to BACS : = 4.76%
5 + 20 + 80
12
BACS to ADMIN : 12 + 18 + 102
= 9.09%
57 58