UNIT 2: COST AND MANAGEMENT ACCOUNTING

MODULE 1: COSTING PRINCIPLES

Topic: Overhead Costs

Students should allocate service department costs and apportion overhead cost. In the use of the repeated
distribution method students should be practised in preparing the statements using three iterations where the third
is the final iteration and would be the closing off of service department costs.

Objective

1. allocate overhead and service department costs.

Focus: Overhead Costs

a) Types of overhead expenses (fixed and semi-fixed).
b) Apportionment (allocation) of overhead costs.
c) Basis for the apportionment (allocation) of costs.
d) Calculation of predetermined overhead recovery rates, using machine hours, direct
labour hours and direct labour costs.
e) Service cost allocation.
Note: Direct, step down, repeated distribution (limited to three iterations where the
third and final iteration would be the closing off of service department costs), and
simultaneous equations methods.

Manufacturing overhead (also referred to as factory overhead, factory burden, and

manufacturing support costs) refers to indirect factory-related costs that are incurred when a
product is manufactured. Along with costs such as direct material and direct labor, the cost of
manufacturing overhead must be assigned to each unit produced to determine the unit cost of
production.

Fixed overhead is a set of costs that do not vary as a result of changes in activity. These costs are
needed in order to operate a business. One should always be aware of the total amount of fixed
overhead costs that a business incurs, so that management can plan to generate a sufficient
amount of contribution margin or gross profit from the sale of products and services to at least
offset the amount of fixed overhead. Otherwise, it is impossible for a business to generate a
profit.

Examples of fixed overhead costs that can be found throughout a business are:

 Rent
 Insurance
 Office expenses
 Administrative salaries
 Depreciation
Examples of fixed overhead costs that are specific to a production area (and which are usually
allocated to produced goods) are:

 Factory rent
 Utilities
 Production supervisory salaries
 Depreciation on production equipment
 Insurance on production equipment, facilities, and inventory

Semi fixed cost or semi variable cost or mixed cost

These are costs that varies with changes in volume but, unlike a variable cost, does not vary in
direct proportion. In other words, this cost contains both a variable and fixed component.
Examples are the rental of a delivery truck, where a fixed rental fee plus a variable charge based
on mileage is made; and power costs, where the expense consists of a fixed amount plus a
variable charge based on consumption.

Apportionment of overhead costs to cost centres/ Activity base

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Terminologies

Cost centre - A department within an organization that does not directly add to profit, but which
still costs an organization money to operate. Examples include maintenance department, research
and development departments, marketing departments, help desks and customer service centers.
Although not always demonstrably profitable, a cost center typically adds to revenue indirectly
or fulfills some other corporate mandate. Money spent on research and development, for
example, may yield innovations that will be profitable in the future. Investments in public
relations and customer service may result in more customers and increased customer loyalty.

Cost objects - is any item, process or activity for which a separate measurement of cost is
required. Examples include: the cost of manufacturing a component or product, the cost of
operating a department, the cost of dealing with an enquiry at a call centre, the cost of an
operation at a hospital or the cost of running the whole hospital.
Cost units - When an individual unit cost is required, examples are the cost of a car, a haircut, a
ton of coal etc.

Cost Allocation - To assign a whole item of cost, or of revenue, to a single cost unit or centre
(department). Where a cost can be clearly identified with a cost centre or cost unit, then it can be
allocated to that cost centre or cost unit. Example the cost of lubricating oil allocated to a
machine shop, or the cost of food allocated to the canteen which prepares meals or cost of repair
racking to store.

Cost Apportionment - This is to assign or spread revenues or costs over two or more cost units or
centres. These are costs which benefit the company as a whole or some departments. This
expenditure cannot be allocated. For example, a company might apportion or assign the cost of
an expensive computer system to the three main areas of the company that use the system. A
company with only one electric meter might apportion the electricity bill to several departments
in the company. Other apportioned costs are rent, insurance etc.

EXPENDITURE

Allocate Apportion

Indirect expense which

are not suitable for
Direct Expenses Indirect expenses allocation.
which arise directly
from the activity of a
particular cost centre
and are discrete
(separate or
individually distinct)
costs

Basis for the apportionment of costs

The basis upon which the apportionment of cost is made varies from cost to cost. The basis
chosen should produce, as far as possible, a fair and equitable share of the common cost for each
of the receiving cost centres. The choice of an appropriate basis is a matter of judgment to suit
the circumstances of the organization and wherever possible there should be a cost/cause
relationship, the nature of the expense and the impact of each cost centre on the amount of
expense incurred or the relative benefit enjoyed by the cost centre.

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Overhead Basis of apportionment to cost centres

Buildings: rent, rates maintenance, On floor area of each cost centre

depreciation, insurance

Heating, Lighting Either on volume of space occupied by cost

centre but may be on floor area

Plant, machinery, and equipment-depreciation On cost or book value of plant etc., in cost
centre

Plant, machinery, and equipment-insurance On cost or replacement value of plant etc., in

cost centre

Costs of storekeeping On number or value of store requisitions

raised by each cost centre

Costs of canteen, personnel dept On number of personnel in each cost centre

administration

Predetermined Overhead Rates

Overheads form part of the total cost of a product or service. Therefore, overheads must be
shared out in some equitable fashion among all the cost units produced or services supplied.
Conventionally, the process by which this is done is known as overhead absorption rate or
overhead recovery (OAR). Typically, an overhead absorption rate is a means of attributing
overheads to a product or service based, for example, on machine hours, direct labour hours and
direct labour costs.

Predetermined overhead absorption rate (OAR) is calculated prior to the accounting period,
using estimated or budgeted figures for overheads and units of the absorption base chosen.

Predetermined OAR for cost centers =

Budgeted total overheads for cost centers

Budgeted total number of units of absorption base ( Machine hours / DL costs / DL hours)

The major reason for this procedure is that the actual overheads and actual number of base units
are not known in total until the end of the period and the actual OAR could not be calculated
until then. This would mean that product costs could not be calculated until the end of the period
and clearly this would introduce unacceptable delays into such procedures such as computing
unit cost, pricing products and making other marketing and operating decisions. The delay in
such decisions until year end, when actual costs are available, would deter / hinder organization
from competing effectively. Therefore, to have timely data for decision making, most firms
estimate their total overhead costs at the beginning of a year, estimate the level of activity for the
year, and develop a predetermined overhead rate based on these estimates.

Overhead Application - This is the assigning of Predetermined Overhead Rate to jobs.

Assume a firm has estimated overhead costs for the coming year of $900 000 and expected
activity is 90 000 direct labour hours. Calculate the predetermined overhead rate using direct
labour hours.

$ 900 000
Predetermined overhead rate = =$ 10 per direct labour hours
90 000 direct labour hours

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Since the number of DL hours charged to a job is known from time tickets, the assignment of
OH costs to jobs is simple, once the predetermined rate has been computed.

Example Ann Wilson worked a total of 8 hours on Job 16. From this time ticket, calculate the
total overhead costs applied to this Job.

$10 per direct labour hours * 8 hours = $80.00

Unit cost calculation

Once a job is completed, its total manufacturing cost is computed by first totaling the costs of
direct materials, direct labour and overheads and summing these individual totals.

Unit cost = Total manufacturing cost

Number of units produced

Under or Over Absorption (Under-applied/Over-applied)

Using predetermined rates, overheads are absorbed into actual production throughout the
accounting period. Because the predetermined rates are based on estimated production and
estimated overheads, invariably, the overheads absorbed by this process do not agree with the
actual overheads incurred for the period.

If the overheads absorbed are greater than actual overheads, this is known as over absorption /
over applied. Conversely, if absorbed overheads are less than actual overheads, this is known as
under absorption or under applied.

Assume, for example, that two companies have prepared the following estimated data for the
year 20X1:
Company

A B

Predetermined overhead rate based on Machine-hours Direct materials cost

Estimated manufacturing overhead for 20X1 $300 000 (a) $120 000 (a)

Estimated machine-hours for 20X1 75 000 (b) -

Estimated direct materials cost for 20X1 - $80 000 (b)

Predetermined overhead rate, (a) / (b) $4 per machine-hour 150% of direct materials cost

Now assume that the actual overhead cost and the actual activity recorded during the year in each
company are as follows:

Company

A B

Actual manufacturing overhead cost $290 000 $130 000

Actual machine-hours 68 000 -

Actual direct materials cost - $90 000

For each company, notice that the actual cost and activity data differ for the estimates used in
computing the predetermined overhead rate. The computation of the resulting under or over
applied overhead for each company is given below:

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Company

A B

Actual manufacturing overhead costs $290 000 $130 000

Manufacturing overhead cost applied to Work in

Process during 20X1:

68 000 actual machine-hours x $4 272,000

$90 000 actual direct materials cost x 150% ____________ 135000

Underapplied (overapplied) overhead $18000 -Underapplied $(5000)-overapplied

For Company A, notice that the amount of overhead cost that has been applied to Work in
Process ($272,000) is less than the actual overhead cost for the year ($290,000). Therefore,
overhead is underapplied. Also notice that the original estimate of overheads in Company A
($300,000) is not directly involved in this computation. Its impact is felt only through the $4
predetermined overhead rate that is used.

For Company B, the amount of overhead cost that has been applied to Work in Process
($134,000), and so a situation of over applied overhead exists.

Disposition of under or overapplied overhead balances

What disposition should be made of any under or overapplied balance remaining in the
manufacturing overhead account at the end of a period? Generally, any balance in the account is
treated in one of two ways:

1. Closed out to cost of goods sold

2. Allocated between Work-in-Process, Finished Goods, and Cost of Goods Sold in
proportion to the ending balance in these accounts.
The choice between these two approaches depends in large part on the amount of under or
overapplied overhead involved. The greater the amount, the more likely a company is to choose
alternative 2.

Summary of overhead Concepts

The amount of overhead cost

that management estimates will
be incurred. This estimate is
made before the Begin in order
to compute the predetermined
Estimated Overhead Cost
overhead rate.

The amount of overhead cost

that is actually incurred during
a period (As shown by
payments for utilities, rent and
so forth).
Actual Overhead Cost The difference between
these two amounts
represent under or
The amount of overhead cost overapplied overhead
that is added (applied) the
Work in Process. the amount
is computed by multiplying
actual activity during a. By the
Applied Overhead cost
predetermined overhead rate

Actual overhead cost - applied overhead cost = underapplied or overapplied overhead

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Closed out to Cost of Goods Sold

If the balance in the manufacturing overhead account is small, most companies will close it out
directly to the cost of goods sold, since this approach is simpler than allocation. Return to the
example of the firm, the entry to close the underapplied overhead to cost of goods sold would be

Cost of Goods Sold……………………………………………………………….84

Manufacturing overhead…………………………………………………………...84

Allocated between accounts

Allocation of under or overapplied overhead between work-in-process, finished goods and cost
of goods sold is more accurate than closing the entire balance into cost of goods sold. the reason
is that allocation assigns overhead cost to where they would have gone in the first place had it
not been for the arrow in estimate going in to the predetermined overhead rate. Although
allocation is more accurate than direct write-off, it is used less often in actual practice because of
the time and difficulty involved in the allocation process most managers believe that the greater
accuracy simply isn't worth the extra effort that allocation requires, particularly when the dollar
amount is small.

Dealing with Under or Over Absorption

The budgeted figures used for calculating the predetermined OARs are based on expected levels
of production and overhead. However, it must be realized that it is the actual costs and
overheads which determine the final profit. This means that the total of the actual costs must
appear in the final profit and loss account and not merely those calculated product costs which
include actual prime cost-plus overheads based on a predetermined OAR.

Accordingly, the amount of under absorbed overheads should be added to total costs before the
profit is calculated and conversely the amount of over absorbed overheads should be subtracted
from total cost.

Illustration

Actual direct material

+ Actual direct labour
Actual prime cost
+ Absorbed overheads
= Calculated production cost
+ Under absorption/ (over absorption)
= Total production cost

Example:

Zamour Ltd makes two products, A and B. Its budgeted output for March is as follows:

Units Machine hours per unit

Product A 1,000 3

Product B 2,000 2

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Budgeted overheads for March are $49,000.

Budgeted Overhead absorption rate will be:

Total machine hours = (3 x 1000) + (2 x 2000) = 7,000

$ 49000
Machine hour OAR = =$ 7
7,000

Overhead absorption rate: each unit of A = $7 x 3 =$21

Each unit of B = $7 x 2 =$14

The budgets are met, the total overheads will be absorbed as follows:

1000 units of A (1,000 x $21) 21,000

2000 units of B (2,000 x $14) 28,000

49,000

1. Meave Company used a predetermined overhead rate last year of $2 per direct labor cost, based
on an estimate of 37500 direct labor hours to be worked during the year. actual cost and activity
during the year were:
Actual manufacturing overhead cost incurred $70500
Actual direct labor hours worked 36000

The under or overapplied overhead last year was

A. $1,500 under applied
B. $1,500 over applied
C. $3,000 underapplied
D. 4500 over applied

2. The Hillary Firm uses a job order costing system. The Firm uses machine hours as a basis for
overhead allocation in its cost center No. 10. cost data for a production are as follows:
Estimated Actual
$ $
Overheads 85 000 82 605
Machine hours 7 500 7 210
Prime cost 125 000 126 000

What is the predetermined overhead rate?

A. $11.33 per machine hour
B. $11.45 per machine hour
C. $28 per machine hour
D. $29 per machine hour

What is the amount of over or under absorbed overhead?

A. $619 under absorption
B. $916 over absorption
C. $916 under absorption
D. $9,116 over absorption
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3. Berkeley company uses a job order cost system. Estimated cost and activity data for the current
year were: manufacturing overhead $150,000; direct labor hours 100000. at the end of the year,
cost records revealed that actual overhead of $160,000 had been incurred and that 105,000 direct
labor always had been worked.

 The predetermined overhead rate for the year was _____________________.

 Manufacturing overhead cost applied to work in progress during the year was _______________.

 The amount of underapplied or overapplied overhead cost for the year

was _____________________.

CAPE ACCOUNTING UNIT 2 PAST PAPER

2012

Define the following terms and give ONE example of EACH:

(a) Overhead allocation [2 marks]
(b) Overhead apportionment [2 marks]
Total 4 marks

2016

Crawle Company Ltd is a manufacturing company which applies overhead to its products based on direct
labour hours. The accounting record for Crawle Company Ltd for 2015 based on direct labour hours. The
accounting record for Crawle Company Ltd for 2015 was as follows:
Budgeted production overhead $875 000
Actual production overhead $925 000
Budgeted direct labour hours 103 125 hours
Actual direct labour hours 112 700 hours

The production overhead cost incurred in December 2015 was $58 000 and the number of direct labour
hours used was 7800.

(i) Compute the predetermined production overhead rate for 2015. [2 marks]
(ii) Calculate the over/under applied overhead for December 2015. [2 marks]

Service Costs
The organizational units in most manufacturing firms can be classified as either production or operating
departments and service (support) departments. These operating departments perform the primary
purpose of the company—to produce goods and services for consumers. Examples of operating
departments are the assembly departments of manufacturing firms and the departments in hotels that take
and confirm reservations.

The costs of service departments are allocated to the operating departments because they exist to support
the operating departments. Examples of service departments are maintenance, administration, cafeterias,
laundries, and receiving. Service departments aid multiple production departments at the same time, and
accountants must allocate and account for all of these costs. It is crucial that these service department
costs be allocated to the operating departments so that the costs of conducting business in the operating
departments are clearly and accurately reflected.

Reasons for allocating service department costs to operating departments

1. To obtain a mutually agreeable price

2. To compute product-line profitability

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3. To predict the economic effects of planning and control
4. To value inventory
5. To motivate managers

Competitive pricing requires an understanding of costs. Only by knowing the cost of each service or
product can the firm create meaningful bids. If costs are not accurately allocated, some costs could be
overstated, resulting in bids that are too high and a loss of potential business. Alternatively, if the costs
are understated, bids could be too low, producing losses on these products.

Good estimates of individual product costs also allow a manager to assess the profitability of individual
products and services. Multiproduct companies need to be sure that all products are profitable, and that
the overall profitability of the firm is not disguising the poor performance of individual products.

By assessing the profitability of various support services, a manager may evaluate the mix of support
services offered by the firm. From this evaluation, executives may decide to drop some support services,
reallocate resources from one to another, re-price certain support services, or exercise greater cost control
in some areas.

For a service organization such as a hospital, inventory valuation is not relevant. However, for
manufacturing organizations special attention must be given to inventory valuation. Rules of financial
reporting (GAAP) require that all direct and indirect manufacturing costs be assigned to the products
produced. Since support department costs are indirect manufacturing costs, they must be assigned to
products. This is accomplished through support department cost allocation.

Allocations also can be used to motivate managers. If the costs of support departments are not allocated to
producing departments, managers may tend to over-consume/ over-use these services. That is they tend to
waste service department resources if they are provided free of charge. By allocating service costs to
operating departments and holding managers of producing departments responsible for the economic
performance of their units/departments, the organization ensures that operating departments use resources
from service departments wisely.

Allocation base

An allocation base is a measure of activity that acts as a cost driver for the department involved. Cost
driver is the factor which influence the level of cost. Typical bases used to apportion or allocate service
costs to production departments are:

Service department Possible bases of apportionment to production cost centers

Maintenance Maintenance labour hours
Maintenance wages
Stores No. of Requisitions
Inspection No. of production employees
No. of inspection tickets
No. of jobs
Production control No. of production employee
Power Metered usage
Personnel dept No. of employees per department
Cafeteria Number of employees
Medical facilities No. of employees, hours worked
Custodial services (taking Measure of square footage occupied
care)

The bases chosen should be one that is judged to be the most equitable way of sharing the service the
department's costs over the departments which use the service.

There are three methods for allocating service department costs:

 The first method, the direct method, is the simplest of the three.
 The second method of allocating service department costs is the step method.
 The third method is the most complicated but also the most accurate. The reciprocal method
(repeated distribution)

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DIRECT METHOD

The direct method is the most widely used method. This method allocates each service department’s
total costs directly to the production departments and ignores the fact that service departments may also
provide services to other service departments. [The direct method allocates costs of each of the service
departments to each operating department based on each department’s share of the allocation base.
Services used by other service departments are ignored.] The Direct method is generally an inaccurate
method of service departments' overheads reallocations and very inaccurate when service departments
receive significant help from each other. This inaccurate method of allocation can lead to distorted
product and service costs and ineffective pricing. Therefore, it is only recommended in cases where
service departments do not depend much on the services of other departments.

Example: Mountain view Hospital has two service department and two operating department as shown
below

Service Department Operating Department

Hospital Custodial services laboratory Daily Patient Care Total
Administration
Department costs before $360,000 $90,000 $261,000 $689,000 $1,400,000
allocation
Labour-hours - 6,000 18,000 30,000 54,000
Proportion of labour hours - 1 3 5 9
9 9 9 9
Space-occupied-square feet 10,000 - 5,000 45,000 60,000
Proportion of space 2 - 1 9 12
occupied 12 12 12 12

Hospital Administration is allocated based on labour hours and Custodial services is based on Space
occupied.

Direct Method Allocation

Service Department Operating Department

Hospital Custodial laboratory Daily Patient Total
Administration services Care
Department costs before $360,000 $90,000 $261,000 $689,000 $1,400,000
allocation

Allocation:
Hospital administration (360,000) 135,000 225,000
costs (3/8, 5/8)*
Custodial Service Cost
(1/10, 9/10)** _______ (90,000) 9,000 81,000
Total costs after $0 $0 $405,000 $995,000 $1,400.000
allocation

*Based on labour hours in the two operating departments, which are 18,000 + 30,000 hours =48,000
hours

**Based on the space occupied by the two operating departments, which is 5,000 sq.ft +45,000 sq.ft
=50,000 sq.ft

Note: that after all the

allocations have been
made, all the

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departmental costs are contained in the two operating departments. These costs will form the basis for
preparing overhead rates and for determining the overall profitability of the operating departments in the
hospital.

THE STEP-DOWN METHOD:

The step-down method is also called the sequential method. This method allocates the costs of some
service departments to other service departments, but once a service department’s costs have been
allocated, no subsequent costs are allocated back to it.

The choice of which department to start with is important. The sequence in which the service departments
are allocated usually affects the ultimate allocation of costs to the production departments, in that some
production departments gain and some lose when the sequence is changed. Hence, production department
managers usually have preferences over the sequence. The most defensible sequence is to start with the
service department that provides the highest percentage of its total services to other service departments,
or the service department that provides services to the greatest number of service departments, or the
service department with the highest costs, or some similar criterion. [This method allocates service costs
to the operating departments and other service departments in a sequential process. The sequence of
allocation generally starts with the service department that has incurred the greatest costs. After this
department’s costs have been allocated, the service department with the next highest costs has its costs
allocated, and so forth until the service department with the lowest costs has had its costs allocated. Costs
are not allocated back to a department that has already had all of its costs allocated.]

Step Method Allocation

Service Department Operating Department

Hospital Custodial laboratory Daily Patient Total
Administration services Care
Department costs before $360,000 $90,000 $261,000 $689,000 $1,400,000
allocation

Allocation:
Hospital administration (360,000) 40,000 120,000 200,000
costs (1/9, 3/9, 5/9)
Custodial Service Cost
(1/10, 9/10)* _______ (130,000) 13,000 117,000
Total costs after $0 $0 $394,000 $1,006,000 $1,400.000
allocation

THE RECIPROCAL METHOD -- REPEATED DISTRIBUTION METHOD (CONTINUOUS

ALLOTMENT)

The reciprocal method is the most accurate of the three methods for allocating service department costs,
because it recognizes shared services among service departments. It is also the most complicated method.

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Repeated distribution method (continuous allotment) is a technique in which costs of each service
department are repeatedly allocated to other departments according to the given percentages until the
balance left in service departments reaches zero. The reciprocal method recognizes all interactions of
support departments. [allocates services department costs to operating departments and other service
departments. Under the reciprocal cost, the relationship between service departments is recognized and
cost is allocated to and from each service department for services provided.

Assume a company has a certain number of production departments and two service departments, A and
B, which benefit from each other. In order to reallocate the service department costs to production
departments using repeated distribution method, we follow the steps given below:

1. Start by allocating the higher service cost first, let it be A to the production departments and the
service department B.
2. Allocate department B's costs (initial cost plus the amount allocated from dept A) to all
production departments and department A.
3. Since the balance in department A is no longer zero after reallocation of department B's cost, we
have to repeat the process by allocating department A's cost again to production departments and
department B.
4. This process of reallocating the service department costs is repeated until the balance remaining
in any service department becomes minimal or you are told the number of iterations to do. When
this occurs allocating the figure to only the production departments.
Example: A company has two service departments and two producing departments. The two service
departments provide service not only to two producing departments but also one another. The costs of
four departments and relationship among them is shown below:

Required: Allocate the cost of service departments to producing departments using repeated distribution
method.

Department A B Y Z
Y 40% 40% -- 20%
Z 20% 50% 30% --
Reallocate the service department costs in the specified percentages using repeated distribution method.

Department A B Y Z
Allocated Overheads 12,000 16,000 7,260 4,000
1. Dept. Y Reallocation 2,904 2,904 (7,260) 1,452
Total 14,904 18,904 0 5,452
2. Dept. Z Reallocation 1,090.4 2,726 1635.6 (5,452)
Total 15,994.4 21,630 1635.6 0
3. Dept. Y Reallocation 654.24 654.24 (1635.6) 327.12
Total 16,648.64 22,284.24 0 327.12
4. Dept. Z Reallocation 65.42 163.56 98.14 (327.12)
Total 16,714.06 22447.80 98.14 0
5. Dept. Y Reallocation 39.256 39.256 (98.14) 19.63
Total 16,753.32 22,487.06 0 19.63
6. Dept. Z Reallocation 3.926 9.815 5.889 (19.63)
Total 16,757.25 22,496.88 5.889 0
7. Dept. Y Reallocation 2.9445 2.9445 (5.889) 0
Total 16,760 22,500 0 0

Calculations

1. A=7260*40%=2,904 | B=7260*40%=2,904 | Z= 7260*20%=1,452

2. A=5452*20%=1,090.4 | B=5452*50%=2726 | Y= 5452*30%=1,635.6

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3. A=1635.6*40%=654.24 | B=1635.6*40%=654.24 | Z= 1635.6*20%=327.12
4. A=327.12*20%=65.42 | B=327.12*50%=163.56 | Y= 327.12*30%=98.14
5. A=98.14*40%=39.256 | B=98.14*40%=39.256 | Z= 98.14*20%=19.63
6. A=19.63*20%=3.926 | B=19.63*50%=9.815 | Y= 19.63*30%=5.889
7. A=5.889*40/80=2.9445 | B=5.889*40/80=2.9445 *(only allocate to A & B, as the figure for Y
is minimal)
THE CAPE ACCOUNTING SYLLABUS ONLY REQUIRE THREE ITERATIONS.

Department A B Y Z
Allocated Overheads 12,000 16,000 7,260 4,000
1. Dept. Y Reallocation 2,904 2,904 (7,260) 1,452
Total 14,904 18,904 0 5,452
2. Dept. Z Reallocation 1,090.4 2,726 1635.6 (5,452)
Total 15,994.4 21,630 1635.6 0
3. Dept. Y Reallocation 817.8 817.8 (1635.6) 0
Total 16,812.20 22,447.80 0 0

1. A=7260*40%=2,904 | B=7260*40%=2,904 | Z= 7260*20%=1,452

2. A=5452*20%=1,090.4 | B=5452*50%=2726 | Y= 5452*30%=1,635.6
3. A=1635.6*40/80=817.8 | B=1635.6*40/80=817.8 (Only allocate to A & B)
While repeated distribution method is simple to understand, it is time consuming and better faster
techniques are available such as simultaneous equation method.

SIMULTANEOUS EQUATION

In simultaneous equation method of allocation of service department costs, we establish simultaneous

equations and solve them to obtain the final balances of production departments. This method accurately
allocates service department costs in the given percentages.

A company has two service departments and two producing departments. The two service departments
provide service not only to two producing departments but also one another. The costs of four
departments and relationship among them is shown below:

Required: Allocate the cost of service departments to producing departments using reciprocal/algebraic
method (Simultaneous equation).

Solution

Let:

Y = $7,260 + 0.3Z —— Eq.1

Z = $4,000 + 0.2Y —— Eq.2

Substituting the value of Z in equation 1:

Y = $7,260 + 0.3($4,000 + 0.2Y)

Y = $7,260 + $1200 + 0.06Y
Y – 0.06Y = $7,260 + $1,200
0.94Y = $8,460

HANDOUT 8~ Prepared by Mrs. S. DaCosta-Walker 13

UNIT 2: COST AND MANAGEMENT ACCOUNTING
MODULE 1: COSTING PRINCIPLES
Y = $8,460/0.94
Y = $9,000

Substituting the value of Y in equation 2:

Z = $4,000 + 0.2(9,000)
Z = $4,000 + $1,800
Z = $5,800

Distribution summary:

Practice Question
1. List TWO purposes for allocating service department costs to products
2. Pegasus Incorporated has four departments of which Rooms Divisions and Guest Services are
production departments. Meanwhile Housekeeping and Catering are service departments. The
distribution of service department costs is as follows:
Service Provided to

Service Housekeeping Catering Rooms Guests

Division Services

Housekeepin $240,000 10% 60% 30%

g

Catering 494,000 5% 80% 15%

Using all methods taught to allocate the service department costs to the production departments.
(Only three iterations for repeated distribution)
References

Garrison, R., Noreen, E. and Brewer, P. (2020) Managerial Accounting 17th Edition. New Jersey: McGraw Hill
Hansen & Mowen. Cost management accounting and control. (4th ed)
Irfanullah Jan (2020).Cost allocation. Retrieved on August 2021 from
(http://accountingexplained.com/managerial/cost-allocation/direct-allocation-method).
Irfanullah Jan (2019). Repeated Distribution. Retrieved on August 23, 2023 from
https://xplaind.com/186995/repeated-distribution-method
Jiambalvo, J. Managerial Accounting. (2nd ed)
Lucey, T. Costing 7th ed
Learneo, Inc (2021).Allocation of Service Department Costs. Retrieved on August 2021.
https://courses.lumenlearning.com/sac-managacct/chapter/allocation-of-service-department-costs/

Repeated Distribution Videos:

https://youtu.be/Rr12oe31ULo
https://youtu.be/NHEiappdpf8

Next topic: Module 2: Costing System

HANDOUT 8~ Prepared by Mrs. S. DaCosta-Walker 14