Lesson 4: Support Department Costs

I thought my students were happy to be in accounting, until I found a note that said,
“Help, we’re being held hostage and forced to look at memes.”
It was signed by my entire class.
- Professor McLaughlin
 Learning Objectives
• Understand how and why firms might use a two-stage allocation

Firms can more accurately apply MOH when they use multiple
departmental MOH rates instead of a single plantwide MOH rate
• Know the difference between an operating and a support department

A support department exists to provide services to operating departments

• See how a two-stage allocation is related to support departments

• Learn 3 techniques for allocating the costs of support departments:

– The Direct Method

This is the easy one
– The Step-Down Method

– The Reciprocal Method This is the hard one

 Today’s Topics
- Description
Two-stage Allocation - Example

Allocating Support - Operating Departments vs. Support

Departments
Department Costs - 3 Methods for Allocating Support Costs

The Direct Method

The Step-down Method

The Reciprocal Method

 Today’s Topics
- Description
Two-stage Allocation - Example

Allocating Support - Operating Departments vs. Support

Departments
Department Costs - 3 Methods for Allocating Support Costs

The Direct Method

The Step-down Method

The Reciprocal Method

 Quick Review
• In Lesson 3, we discussed how manufacturers
apply MOH using a predetermined overhead rate
– We noted that some firms use a single plantwide MOH rate,
while other firms use a different rate for each department
• The latter process is called a two-stage allocation
• We will now discuss how a two-stage allocation is performed
 Two-stage Allocation
• Here is an overview of the process we are going to follow:
– Stage 1: Allocate manufacturing overhead to departments
– Stage 2: Assign manufacturing overhead using departmental rate

Manufacturing Overhead

Machining Department Assembly Department

MOH Rate = $X per machine hour MOH Rate = $X per direct labor hour

Why would a firm do this when it would easier to use a single plantwide MOH rate?
Because it can result in more accurate costing
 Example
• A company expects to incur $20 million in MOH costs. Assume:
– The firm assigns $12 million in MOH to its Machining Department
– The firm assigns $8 million in MOH to its Assembly Department
• The Machining Department assigns MOH on the basis of machine hours
• The Assembly Department assigns MOH on the basis of direct labor hours

Machining Department ($12 m) Manufacturing Overhead ($20m) Assembly Department ($8m)

MOH Rate = $12m/6m = $2 per mh MOH Rate = $8m/500k = $16 per dlh

Machining Dept Assembly Dept

MOH costs assigned: $12,000,000 $8,000,000 The Machining Department will apply
MOH at a rate of $2 per machine hour.
Budgeted Machine Hours: $ 6,000,000
The Assembly Department will apply
Budgeted Direct Labor Hours: 500,000 MOH at a rate of $16 per direct labor
Departmental MOH Rate: ? $2.00 ? $16.00 hour.
 Question
• But how does a company determine how much
MOH to assign to each department?
– Some MOH costs (e.g., the supervisor of the machining
department) are clearly related to a certain department
– The company might assign other MOH (e.g., heat costs)
on the basis of square footage or other measures

• But there is a more difficult issue here…

– Each production department might receive support from
various support departments
– Next, we will discuss how to allocate the costs of these
support departments to the production departments
 Today’s Topics
- Description
Two-stage Allocation - Example

Allocating Support - Operating Departments vs. Support

Departments
Department Costs - 3 Methods for Allocating Support Costs

The Direct Method

The Step-down Method

The Reciprocal Method

 What is a Support Department?
• Large organizations have operating departments
and support departments
– Support departments do not engage in the main
operations of the organization
– Instead, they assist the operating departments
Allocating support department costs is necessary to perform the two-stage
allocation for manufacturers that use multiple departmental MOH rates

Non-manufacturers may also allocate support costs to operating

departments for internal decision-making (e.g., calculating the profit of an
operating department)

FYI, the terms “support department” and “service department” mean the
same thing
 Example
• Let’s take a business school
– The accounting, finance, and
marketing departments are
operating departments
– IT and HR are support
departments
The academic departments are
“operating” because the purpose of
a university is to create and share
knowledge
IT is a support department because
providing IT services is not the
primary role of a university

Operating Accounting Finance Marketing

Departments Department Department Department

Support IT HR
Departments Department Department
Allocating Support Department Costs
• Cost allocation is difficult when support departments provide
services to each other
• There are 3 ways to allocate the costs of a support department:

– Direct Method
• Allocates no costs between support departments

– Step-down Method
• Allocates some costs between support departments

– Reciprocal Method
• Allocates all costs between support departments
 Today’s Topics
- Description
Two-stage Allocation - Example

Allocating Support - Operating Departments vs. Support

Departments
Department Costs - 3 Methods for Allocating Support Costs

The Direct Method

The Step-down Method

The Reciprocal Method

 Direct Method
• This is the simplest method
– It only allocates the costs of a support
department to operating departments
– This ignores the fact that support departments
provide services to other support departments
 Example
• Let’s use the Direct Method for PolyOne
– PolyOne has two operating departments:
1. Mixing
2. Injection Molding
 PolyOne
• PolyOne has also two support
departments: Maintenance and Toolroom
– Each support department provides services to the two
operating departments…
– But they also provide services to each other

Operating Injection
Mixing
Molding
Departments Department
Department

Support Maintenance Toolroom

Departments Department Department
 Overview
Here are the data: We need to know
Operating Departments how the
Mixing Injection Maintenance and
Dept. Molding Toolroom costs
Costs assigned: ? ? should be divided
between the
from Maintenance
Mixing and
from Toolroom Injection Molding
departments

Maintenance Provider of the Service

incurred $30,000 of Maintenance Toolroom Toolroom incurred
costs $40,000 of costs
Costs to be assigned $30,000 $40,000
Hours of usage:
These are the
Mixing 12,000 15,000
hours the
Injection Molding 4,000 15,000 Toolroom spent
Toolroom 4,000 doing work for
User of the Service
Maintenance 10,000 each department
 The Direct Method
1. Ignore the services support departments provide to each other
2. Allocate costs based on relative usage
Operating Departments
Mixing Injection
$22,500 + $20,000 Dept. Molding $7,500 + $20,000
Costs assigned: $42,500 $27,500
75% × $30,000 from Maintenance $22,500 $7,500
25% × $30,000
from Toolroom $20,000 $20,000
25% × $30,000
75% × $30,000 Provider of the Service
Maintenance
Maintenance Toolroom
Costs to be assigned $30,000 $40,000
Mixing is responsible Hours of usage: Injection Molding is
for 75% Mixing 12,000 15,000 responsible for 25%
(12,000/16,000) of Injection Molding 4,000 15,000 (4,000/16,000) of
Maintenance and Toolroom 4,000 Maintenance and
50% (15,000/30,000) Maintenance 10,000 50% (15,000/30,000)
of Toolroom costs of Toolroom Costs
 Two-stage Allocation
• Now that we’ve assigned the costs of the support
departments to our operating departments, we can
return to our two-stage allocation and calculate
MOH rates for each production department
– Assume the following:
• Prior to the allocation of support costs, the Mixing Department was
budgeted $100,000 of MOH and the Injection Molding Department
was budgeted $105,000 of MOH
• Each department calculates its MOH rate using machine hours

If you’re wondering Mixing Injection

Dept. Molding Dept. These are the
where I got the costs we allocated
$100,000 and Budgeted MOH (non-support costs) $100,000 $105,000
using the direct
$105,000 figures, I Budgeted MOH (support costs) $42,500 $27,500 method
made them up out of Budgeted MOH (total) $142,500 $132,500
thin air for purposes
Budgeted Machine Hours: 7,000 6,800
of this example
Departmental MOH Rate: $20.36
? $19.49
?
 Quiz A
• Let’s say a manufacturer has:
– 2 operating departments (Assembly & Testing)
• A MOH rate is calculated for each department using direct labor hours as the activity basis
– 2 support departments (Janitorial & Info Systems)
• It needs to assign support costs to its operating departments so it can calculate departmental MOH
rates (via a two-stage allocation)

• If the Direct Method is used to assign support costs, what is the MOH rate
for each operating department?
Assembly Testing Provider of the Service
Dept. Dept.
Janitorial Info. Systems
Budgeted MOH (non-support costs) $500,000 $800,000
Costs to be assigned $96,000 $500,000
Budgeted MOH (support costs) ? ?
Hours of usage:
Budgeted MOH (total) ? ?
Assembly 1,000 840,000
Budgeted Direct Labor Hours: 45,000 70,000
Testing 8,000 120,000
Using Dept.

Info. Systems 1,000

Janitorial 240,000
 Today’s Topics
- Description
Two-stage Allocation - Example

Allocating Support - Operating Departments vs. Support

Departments
Department Costs - 3 Methods for Allocating Support Costs

The Direct Method

The Step-down Method

The Reciprocal Method

 Step-down Method
• With the Step-down Method (aka Sequential Allocation
Method) we first need to rank the support departments
– Let’s rank the Maintenance Department #1
– Let’s rank the Toolroom Department #2
• Now we’ll use the Step-down Method on our data from before

Operating Injection
Mixing
Molding
Departments Department
Department

Support #1
Maintenance Toolroom
#2
Departments Department Department
 Example
• With Step-down, we allocate some of the Maintenance Department’s
costs to the Toolroom Department
– When allocating the costs of the toolroom, we do NOT allocate any
of the Toolroom’s costs back to Maintenance
Operating Departments
Mixing Injection
Molding
Costs assigned: $41,000 $29,000
12/20 × $30,000 from Maintenance $18,000 $6,000
4/20 × $30,000
15/30 × $46,000 from Toolroom $23,000 $23,000
15/30 × $46,000
Provider of the Service
$40,000 + (4/20 × $30K)
Maintenance Toolroom
Costs to be assigned $30,000 $46,000
$40,000 Toolroom costs
We ranked the
Mixing 12,000 15,000 increase from $40k
Maintenance
Injection Molding 4,000 15,000 to $46k because $6k
Department #1, so
Toolroom 4,000 of Maintenance is
we’ll allocate its
allocated to
costs first. Maintenance 10,000
Toolroom
This is ignored
 Two-stage Allocation
• Now that we’ve assigned the costs of the support
departments to our operating departments, we can
return to our two-stage allocation and calculate MOH
rates for each production department
– Assume the following:
• Prior to the allocation of support costs, the Mixing Department was
budgeted $100,000 of MOH and the Injection Molding Department
was budgeted $105,000 of MOH
• Each department calculates its MOH rate using machine hours
Mixing Injection
Dept. Molding Dept.
Budgeted MOH (non-support costs) $100,000 $105,000
Budgeted MOH (support costs) $41,000 $29,000
Budgeted MOH (total) $141,000 $134,000
Budgeted Machine Hours: 7,000 6,800
Departmental MOH Rate: ?
$20.14 ?
$19.71
 Quiz B
• Let’s say a manufacturer has:
– 2 operating departments (Assembly & Testing)
• A MOH rate is calculated for each department using direct labor hours as the activity basis
– 2 support departments (Janitorial & Info Systems)
• It needs to assign support costs to its operating departments so it can calculate departmental MOH rates
(via a two-stage allocation)

• If the Step-down Method is used to assign support costs, what is the MOH
rate for each operating department? Assume Janitorial is ranked first.
Assembly Testing Provider of the Service
Dept. Dept.
Janitorial Info. Systems
Budgeted MOH (non-support costs) $500,000 $800,000
Costs to be assigned $96,000 $500,000
Budgeted MOH (support costs) ? ?
Hours of usage:
Budgeted MOH (total) ? ?
Assembly 1,000 840,000
Budgeted Direct Labor Hours: 45,000 70,000
Testing 8,000 120,000
Using Dept.

Info. Systems 1,000

Janitorial 240,000
 Today’s Topics
- Description
Two-stage Allocation - Example

Allocating Support - Operating Departments vs. Support

Departments
Department Costs - 3 Methods for Allocating Support Costs

The Direct Method

The Step-down Method

The Reciprocal Method

 Reciprocal Method
• With the Reciprocal Method, we allocate support
department costs among all support departments
– We do this using a system of linear equations
– Let’s return to the data from our example
 Overview 10,000/40,000 = 0.25

The cost of the Maintenance Department is M = $30,000 + 0.25T

$30,000 plus 25% of the Toolroom’s costs,
because the Toolroom Department spent 25%
of its time helping Maintenance T = $40,000 + 0.2M
Operating Departments
We must now solve this 4,000/20,000 = 0.2
system of equations to Mixing Injection
Dept. Molding
find M and T
Costs assigned: ? ?

Provider of the Service

Maintenance Toolroom
Dept. Dept.
Costs to be assigned $30,000 $40,000
Hours of usage:
Mixing 12,000 15,000
Injection Molding 4,000 15,000
Toolroom 4,000
User of the Service
Maintenance 10,000
 Solving the Linear Equations
M = $30,000 + 0.25T
T = $40,000 + 0.2M
M = $30,000 + (0.25)($40,000 + 0.2M)
M = $30,000 + $10,000 + 0.05M
M = $40,000 + 0.05M
0.95M = $40,000
M = $42,105
Plugging in $42,105 into either equation above tells us T
= $48,421
If you’re thinking, “Hey, $42,105 and $48,421 add up to more than the $70,000
total cost of the Maintenance and Toolroom departments” don’t worry.
We’re not going to allocate 100% of the $42,105 and the $48,421
 Overview
These figures were
M = $42,105 calculated with our T = $48,421
system of equations

Mixing: ( * $42,105) + ( * $48,421) = $43,421

Injection Molding: ( * $42,105) + ( * $48,421) = $26,579

These numbers add up to $70,000

(the total cost of the Maintenance
and Toolroom departments) Provider of the Service
Maintenance Toolroom
Costs to be assigned $30,000 $40,000
Operating Departments Hours of usage:
Mixing
Mixing Injection
Injection Mixing 12,000 15,000
Dept.
Dept. Molding
Molding Injection Molding 4,000 15,000
Costs assigned: $43,421
? $26,579
? Toolroom 4,000
Maintenance 10,000
 Two-stage Allocation
• Now that we’ve assigned the costs of the support
departments to our operating departments, we can
return to our two-stage allocation and calculate MOH
rates for each production department
– Assume the following:
• Prior to the allocation of support costs, the Mixing Department was
budgeted $100,000 of MOH and the Injection Molding Department
was budgeted $105,000 of MOH
• Each department calculates its MOH rate using machine hours
Mixing Injection
Dept. Molding Dept.
Budgeted MOH (non-support costs) $100,000 $105,000
Budgeted MOH (support costs) $43,421 $26,579
Budgeted MOH (total) $143,421 $131,579
Budgeted Machine Hours: 7,000 6,800
Departmental MOH Rate: $20.49
? $19.35
?
 Quiz C
• Let’s say a manufacturer has:
– 2 operating departments (Assembly & Testing)
• A MOH rate is calculated for each department using direct labor hours as the activity basis
– 2 support departments (Janitorial & Info Systems)
• It needs to assign support costs to its operating departments so it can calculate departmental MOH rates
(via a two-stage allocation)

• If the Reciprocal Method is used to assign support costs, what is the MOH
rate for each operating department?
Assembly Testing Provider of the Service
Dept. Dept.
Janitorial Info. Systems
Budgeted MOH (non-support costs) $500,000 $800,000
Costs to be assigned $96,000 $500,000
Budgeted MOH (support costs) ? ?
Hours of usage:
Budgeted MOH (total) ? ?
Assembly 1,000 840,000
Budgeted Direct Labor Hours: 45,000 70,000
Testing 8,000 120,000
Using Dept.

Info. Systems 1,000

Janitorial 240,000