Inter-department Cost Allocations

The Need for Cost Allocations

Operating Departments
Service Departments

Carry out the manufacturing operations

Provide support to the operating departments

The Need for Cost Allocations

How are service department costs charged to operating departments?
We identify the factor that drives costs in the service department. This cost driver is used as the allocation base.

The Need for Cost Allocations

Service Department (Cafeteria) Service Department (Accounting) Service Department (Personnel)
First Stage Allocations Service department costs are allocated to operating departments.

Operating Department (Machining) Operating Department (Assembly)

The Products

The Need for Cost Allocations

Service Department (Cafeteria) Service Department (Accounting) Service Department (Personnel)
Second Stage Allocations Operating department overhead costs and allocated service department costs are applied to products.

Operating Department (Machining) Operating Department (Assembly)

The Products

Interdepartmental Services
Problem Allocating costs when service departments provide services to each other Solutions

Direct Method
Step method Reciprocal method

Departmental costs and benefit patterns

Service Department Cafeteria Custodial

Allocation Base Number of employees Square feet occupied

Note that each of the service departments receives reciprocal benefits.

Departmental costs and benefit patterns

It is sometimes useful to express the benefit patterns of the service departments in percentage terms:
Service departments CAF CUS $600,000 $480,000 -30% 20% -Operating departments MACH ASMB $100,000 $100,000 20% 50% 60% 20% Totals $1,280,000 100% 100%

Initial charges CAF benefits (%) CUS benefits (%)

Direct Method
Interactions between service departments are ignored and all costs are allocated directly to operating departments.

Service Department (Cafeteria)

Operating Department (Machining)

Service Department (Custodial)

Operating Department (Assembly)

Direct Method Example

Service Department Cafeteria Custodial

Allocation Base Number of employees Square feet occupied

The direct method will ignore the services provided by service Departments to other service departments. If so, what proportion Of the custodial departments costs will be allocated to each production dept.?

Direct Method Example

5,000 $480,000 15,000 + 5,000

= $120,000

Allocation base: Square feet occupied

Step Method
Service Department (Cafeteria) Operating Department (Machining)

Once a service departments costs are allocated, other service department costs are not allocated back to it.

Service Department (Custodial)

Operating Department (Assembly)

How do we identify the order in which the service department costs are to be allocated? Does it matter if Custodial costs are allocated first (before the Cafeteria costs)?

Step Method #1: Cafeteria allocated first.

Custodial will have a new total to allocate to operating departments; its own costs plus those costs allocated from the cafeteria.

Service Department (Cafeteria)

Operating Department (Machining)

Service Department (Custodial)

Service departments CAF CUS $600,000 $480,000 -30% 20% --

Operating Department (Assembly)

Operating departments MACH ASMB $100,000 $100,000 20% 50% 60% 20% Totals $1,280,000 100% 100%

Initial charges CAF benefits (%) CUS benefits (%)

Step Method #1 Example

Service departments Operating departments Totals Service Department Allocation Base CAF CUS MACH ASMB Initial charges $600,000 $480,000 $100,000 $100,000 $1,280,000 CAF benefits (%)Cafeteria -30% Number of employees 100% 20% 50% CUS benefits (%) 20% -60% 20% Custodial Square feet occupied 100%

Step Method#1 Example

Step Method #2: Custodial allocated first.

Cafeteria will have a new total to allocate to operating departments; its own costs plus those costs allocated from the custodial department.

Service Department (Custodial)

Operating Department (Machining)

Service Department (Cafeteria)

Service departments CAF CUS $600,000 $480,000 -30% 20% --

Operating Department (Assembly)

Operating departments MACH ASMB $100,000 $100,000 20% 50% 60% 20% Totals $1,280,000 100% 100%

Initial charges CAF benefits (%) CUS benefits (%)

Step Method #2 Example

Reciprocal Method
Service Department (Cafeteria) Operating Department (Machining)

Interdepartmental services are given full recognition rather than partial recognition as with the step method.

Service Department (Custodial)

Operating Department (Assembly)

Question: Is the step method always more accurate than the direct method? In order to answer this question, we must know the correct answer, I.e., the reciprocal method results.

Reciprocal Method of Interdepartmental Cost Allocation

First, it is useful to express each service departments benefit pattern in percentages:

Service departments CAF CUS $600,000 $480,000 -30% 20% -Operating departments MACH ASMB $100,000 $100,000 20% 50% 60% 20% Totals $1,280,000 100% 100%

Initial charges CAF benefits (%) CUS benefits (%)

Reciprocal Method of Interdepartmental Cost Allocation

1. Define the total costs in each of the service departments as follows:

Total cost = Initial charges + allocations from other cost pools

Initial charges CAF benefits (%) CUS benefits (%)

Service departments CAF CUS $600,000 $480,000 -30% 20% --

Operating departments MACH ASMB $100,000 $100,000 20% 50% 60% 20%

Totals $1,280,000 100% 100%

Reciprocal Method of Interdepartmental Cost Allocation

1. Define the total costs in each of the service departments as follows:

Total cost = Initial charges + allocations from other cost pools

Cafeteria: CAF = $ 600,000 + (.20) CUS Custodial: CUS = $ 480,000 + (.30) CAF

Initial charges CAF benefits (%) CUS benefits (%)

Service departments CAF CUS $600,000 $480,000 -30% 20% --

Operating departments MACH ASMB $100,000 $100,000 20% 50% 60% 20%

Totals $1,280,000 100% 100%

Reciprocal Method of Interdepartmental Cost Allocation

1. Define the total costs in each of the service departments as follows:

Total cost = Initial charges + allocations from other cost pools

Cafeteria: CAF = $ 600,000 + (.20) CUS Custodial: CUS = $ 480,000 + (.30) CAF Solution: CAF = $ 740,000 * CUS = $ 702,000 * * Solution amounts are rounded to the nearest $1,000.

Reciprocal Method of Interdepartmental Cost Allocation

1. Define the total costs in each of the service departments as follows:

Total cost = Initial charges + allocations from other cost pools

Cafeteria: CAF = $ 600,000 + (.20) CUS Custodial: CUS = $ 480,000 + (.30) CAF Solution: CAF = $ 740,000 * CUS = $ 702,000 * * Solution amounts are rounded to the nearest $1,000. 2. Allocate costs to the operating departments based on their percentage use of the allocation base (see next slide)

Reciprocal Method of Interdepartmental Cost Allocation

Cafeteria: CAF = $ 600,000 + (.20) CUS =$740,000 Custodial: CUS = $ 480,000 + (.30) CAF =$702,000

Solution: MACH=$100,000 + (.20)CAF + (.60)CUS) =$100,000 + $148,000 + $421,000 =$669,000 ASBY=$100,000 + (.50)CAF + (.20)CUS) =$100,000 + $370,000 + $141,000 =$611,000
Initial charges CAF benefits (%) CUS benefits (%) Service departments CAF CUS $600,000 $480,000 -30% 20% -Operating departments MACH ASMB $100,000 $100,000 20% 50% 60% 20% Totals $1,280,000 100% 100%

Comparison of Methods *
* Solution amounts are rounded to the nearest $1,000.

Allocation method Direct Step #1 Step #2

Machining $ 631,000 $ 715,000 $ 587,000

Assembly $ 649,000 $ 565,000 $ 693,000

Total $ 1,280,000 $ 1,280,000 $ 1,280,000

Reciprocal

$ 669,000

$ 611,000

$ 1,280,000

Note that in this case, the direct method provides costs that are nearest to the correct costs, as determined by the reciprocal method. This may not always be the case.

Allocating Costs by Behavior

Variable Costs Fixed Costs

Charge to operating departments based on the usage of the allocation base.

Allocate to operating departments in proportion to the long-term capacity required by the operating department.

Handout 8 (a): Interdepartmental Allocations, Alternative Methods

The Nestling company has two support departments, Custodial (CU) and Repair (RP). All support department costs are allocated to production departments A and B. The service department work done in the most recent period was distributed as follows (in percentages): Services used by: CU Services supplied by: CU RP -20% 40% -15% 60% 45% 20% 100% 100% RP A B Total

The total variable costs incurred in the two support departments were as follows: $ 315,000 in Department CU and $ 150,000 in Department RP. Required:

(a)

Determine the total dollar amounts of support department costs that would be allocated to each of the producing departments using the direct method. Allocation to A: Allocation to B: $________________________ $________________________

Services used by: CU Services supplied by: CU RP -20% 40% -15% 60% 45% 20% 100% 100% RP A B Total

Required: (a) Determine the total dollar amounts of support department costs that would be allocated to each of the producing departments using the direct method. Services used by: CU Initial charges Services supplied by: CU RP Total charges -($315,000) ($150,000) -$78,750 $112,500 $191,250 $236,250 $37,500 $273,750 $465,000 $315,000 RP $150,000 A -B -Total $465,000

Allocation to A: Allocation to B:

$_________191,250_______ $_________273,750_________

Services used by: CU Services supplied by: CU RP -20% 40% -15% 60% 45% 20% 100% 100% RP A B Total

(b) Determine the dollar amounts of support department costs that would be allocated each department A using the step method, using the ordering of the departments shown above (i.e., CU first, and RP second).

Services used by: CU Services supplied by: CU RP -20% 40% -15% 60% 45% 20% 100% 100% RP A B Total

(b) Determine the dollar amounts of support department costs that would be allocated each department A using the step method, using the ordering of the departments shown above (i.e., CU first, and RP second).

Services used by: CU Initial charges Services supplied by: CU RP Total charges -($315,000) $126,000 ($276,000) -$47,250 $207,000 $254,250 $141,750 $69,000 $210,750 $465,000 $315,000 RP $150,000 A -B -Total $465,000

(c) Determine the dollar amounts of support department costs that would be allocated to each of the producing departments using the reciprocal method. First, set up the simultaneous equations and solve for the total costs in the service departments:
Services used by: CU Services supplied by: CU RP -20% 40% -15% 60% 45% 20% 100% 100% RP A B Total

(c) Determine the dollar amounts of support department costs that would be allocated to each of the producing departments using the reciprocal method. First, set up the simultaneous equations and solve for the total costs in the service departments:
Services used by: CU Services supplied by: CU -20% 40% -15% 60% 45% 20% 100% 100% RP A B Total

CU = $315,000 + (.2) RP RP = $150,000 + (,4) CU

RP

(c) Determine the dollar amounts of support department costs that would be allocated to each of the producing departments using the reciprocal method. First, set up the simultaneous equations and solve for the total costs in the service departments:
Services used by: CU Services supplied by: CU RP -20% 40% -15% 60% 45% 20% 100% 100% RP A B Total

CU = $315,000 + (.2) RP RP = $150,000 + (,4) CU

Solution: CU = $375,000 RP = $300,000 Allocation to A: A = (.15) ($375,000) + (.60) ($300,000) = $236,250 Allocation to B: B = (.45) ($375,000) + (.20) ($300,000) = $228,750