Cost Allocation

Unit 4

Learning Objective 1

Allocation of Service Department Cost

Department Cost
Producing Departments which include the production lines, are the cost accumulation centers in which work is performed directly on the goods being produced. Service Departments which include such activities as maintenance, personnel, employee services, and the provision of heat, power and light are necessary for the entire factory including the producing departments to remain in operation.

Operating Departments
An operating department carries out the central purpose of the organization
The Surgery Department at Mount Sinai Hospital. The Geography Department at the University of Washington.

A Production Department at Mitsubishi.

Service Departments
Service departments do not directly engage in operating activities.
The Accounting Department at Macys. The Human Resources Department at Walgreens.

Methods to Allocate Support Department Costs

Single-rate methodallocates costs in each cost pool

(service department) to cost objects (production departments) using the same rate per unit of a single allocation base
No distinction is made between fixed and variable costs

in this method.

Methods to Allocate Support Department Costs

Dual-rate methodsegregates costs within each cost

pool into two segments: a variable-cost pool and a fixed-cost pool. Each pool uses a different cost-allocation base.

Allocation Method Trade-Offs

Single-rate method is simple to implement, but treats

fixed costs in a manner similar to variable costs. Dual-rate method treats fixed and variable costs more realistically, but is more complex to implement.

Allocation Bases

Under either method, allocation of support costs can be based on one of the three following scenarios:
1. 2. 3.

Budgeted overhead rate and budgeted hours Budgeted overhead rate and actual hours Actual overhead rate and actual hours

Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, whereas actual will not be known with certainty until the end of the period

Level to use

Activity Level to Use

Factors to be considered in the computation of Overhead Rate

ACTIVITY LEVEL TO USE
In the estimation of manufacturing overhead, as well as the estimation of the base to be used for allocation, it is important to determine what capacity of production should be adopted. a. Ideal capacity b. Practical capacity c. d. Master-budget capacity Normal capacity

Activity Level to Use

a. Ideal or Theoretical is the level of capacity based on producing at full efficiency. b. Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions, such as scheduled maintenance time, shutdowns for holidays and so on. Note: Both theoretical and practical capacity measures capacity in terms of WHAT A PLANT CAN SUPPLY - available capacity. With difficulty, practical capacity is attainable.

Activity Level to Use

c. Master-budget capacity is the level of capacity utilization that managers expect for the current budget period, which is typically one year. d. Normal capacity is the level of capacity utilization that satisfies average customer demand over a period (say two or three years) that includes seasonal, cyclical and trend factors. This capacity is commonly used in the computations of overhead rates. Note:
In contrast, normal and master budget capacity utilization measures capacity level in terms of DEMAND for the output of the plant, that is the amount of available capacity the plant expects to use based on the demand for its products.

Predetermined Overhead Rate and Capacity

Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base has been criticized because: 1.Basing the predetermined overhead rate upon budgeted activity results in product costs that fluctuate depending upon the activity level. 2.Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use.

Capacity-Based Overhead Rates

Criticisms can be overcome by using estimated total units in the allocation base at capacity in the denominator of the predetermined overhead rate calculation. Lets look at the difference!

An Example

Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. What is the predetermined overhead rate?

An Example
Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year.
Traditional = Method Capacity Method $100,000 40,000 $100,000 50,000

= $2.50 per unit

= $2.00 per unit

Income Statement Preparation Capacity

Actual volume Selling price Variable production cost Fixed manufacturing overhead Capacity Predetermined overhead rate Fixed selling and admin. expense Revenue Cost of goods sold Gross margin Cost of idle capacity Selling and admin. expense Net operating income 40,000 $40.00 $24.00 $100,000 50,000 $2.00 $500,000 $ 1,600,000 1,040,000 560,000 20,000 500,000 $ 40,000 cases per case per case per year cases per case per year

Allocation Costs of Multiple Support Departments

Direct Method

Step-Down Method

Reciprocal Method

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

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

Service Department (Custodial)

Operating Department (Assembly)

Direct Method An Example

Service Department Cafeteria Custodial

Allocation Base Number of employees Square feet occupied

Direct Method An Example

How much of the Cafeteria and Custodial costs should be allocated to each operating department using the direct method of cost allocation?

Direct Method An Example

20 $360,000 = $144,000 20 + 30 Allocation base: Number of employees

Direct Method An Example

$360,000

30 = $216,000 20 + 30

Allocation base: Number of employees

Direct Method An Example

25,000 $90,000 25,000 + 50,000

= $30,000

Allocation base: Square feet occupied

Direct Method An Example

50,000 $90,000 25,000 + 50,000

= $60,000

Allocation base: Square feet occupied

Step-Down 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)

Step-Down Method

Also called the sequential allocation method Allocates support-department costs to other support departments and to operating departments in a sequential manner Partially recognizes the mutual services provided among all support departments

Step-Down Method An Example

We will use the same data used in the direct method example.

Service Department Cafeteria Custodial

Allocation Base Number of employees Square feet occupied

Step-Down Method An Example

Allocate Cafeteria costs first since it provides more service than Custodial.

Step-Down Method An Example

10 $360,000 10 + 20 + 30

= $60,000

Allocation base: Number of employees

Step-Down Method An Example

20 $360,000 10 + 20 + 30

= $120,000

Allocation base: Number of employees

Step-Down Method An Example

30 $360,000 10 + 20 + 30

= $180,000

Allocation base: Number of employees

Step-Down Method An Example

New total = $90,000 original Custodial cost plus $60,000 allocated from the Cafeteria.

Step-Down Method An Example

25,000 $150,000 25,000 + 50,000

= $50,000

Allocation base: Square feet occupied

Step-Down Method An Example

50,000 $150,000 25,000 + 50,000

= $100,000

Allocation base: Square feet occupied

Reciprocal or Algebraic 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)

This process requires three steps:

1.

Express support department costs and reciprocal relationships in the form of Linear Equations. Solve the set of Linear Equations to obtain the complete reciprocated costs of each support department.

2.

3.

Allocate the complete reciprocated costs of each support department to all other departments (both support and operating departments)

Reciprocal Method An Example

We will use the same data used in the direct method example.

Service Department Cafeteria Custodial

Allocation Base Number of employees Square feet occupied

Reciprocal Method An Example

Cafeteria Machining Assembly Cafeteria Custodial 33.33% 50% 16.67% Custodial 31.25% 62.5% 6.25% -

Cafeteria = $360,000 + .0625 (Custodial) Custodial = $90,000 + .1667 (Cafeteria) Cafeteria = $360,000 + .0625 ($90,000 +.1667 Cafeteria) = $360,000 + $5,625 + .0104 Cafeteria = $365,625 / .9896 = $369,467 Custodial = $90,000 +.1667 ($369,467) = $90,000 + $61,590 = $151,590

Reciprocal Method An Example

Cafeteria Machining Assembly Cafeteria Custodial 33.33% 50% 16.67% Custodial 31.25% 62.5% 6.25% -

Machining
Budgeted FO Allocated FO Cafeteria Custodial Total FO $123,143 $ 47,373 $570,516 $400,000

Assembly
$700,000 $184,734 $ 94,743 $979,477

Cafeteria
$ 360,000 ($369,467) $ -7 9,474

Custodial
$ 90,000 $ 61,590 ($151,590) -

Data Used in Cost Allocation Illustrations

Reciprocal Allocation Method (Repeated Iterations) Illustrated

Choosing Between Methods

Reciprocal is the most precise. Direct and step-down are simple to compute and understand. Direct method is widely used.

End of Unit 4