Cost Allocation of Support Dept and Revenues

Chapter 15
Allocation of Support- Department Costs,

and
Revenues
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Learning Objectives
15.1 Understand the reason to allocate support (service) department cost
15.2 Allocate multiple support-department costs using the direct method, the
step-down method and the reciprocal method
15.3 Understand how bundling of products causes revenue allocation issues
and the methods managers use to allocate revenues
Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
Production vs Support Department
• Operating (production) department—directly adds value to a product or

service.
• Support (service) department—provides the services that assist other
internal departments (operating departments and other support
departments) in the company.
Why allocate support (service) department
costs ?
Department and Motivate managers to

Product Costing do cost efficiency
3 Phases in Departmental Approach
Departmental Approach Example
Beary Company manufactures two products and has two
production departments (P-1 and P-2) and two service
departments (S-1 and S-2). Beary uses labor-hours (DLH) to
allocate indirect labor costs and machine-hours (MH) to
allocate indirect materials costs.
Total Total
S-1 S-2 P-1 P-2 Hours Amount
Labor-hours 1,800 1,200 3,600 5,400 12,000
Machine-hours 320 160 1,120 1,600 3,200
Direct costs $ 1,600 $ 5,500 $ 15,500 $ 13,400 $ 36,000
Indirect labor 25,000
Indirect materials Not Traceable 5,000
$ 66,000
7-
Departmental Approach: Phase 1
S-1 S-2 P-1 P-2 Total
Direct labor-hours (DLH) 1,800 1,200 3,600 5,400 12,000
Percent 15% 10% 30% 45% 100%
Machine-hours 320 160 1,120 1,600 3,200
Percent 10% 5% 35% 50% 100%
Phase 1: Trace Direct Costs and Allocate Overhead Costs to Departments
Direct costs $ 1,600 $ 5,500 $ 15,500 $ 13,400 $ 36,000
OVH cost to departments:
Indirect labor (DLH) 3,750 2,500 7,500 11,250 $ 25,000
Indirect materials (MH) 500 250 1,750 2,500 $ 5,000
Total for all departments $ 5,850 $ 8,250 $ 24,750 $ 27,150 $ 66,000
Indirect labor cost rate = $25,000/12,000 = $2.0833

7-7

Percent 15% 10% 30% 45% 100%
Machine-hours 320 160 1,120 1,600 3,200
Percent 10% 5% 35% 50% 100%
Direct costs $ 1,600 $ 5,500 $ 15,500 $ 13,400 $ 36,000
Indirect material cost rate = $5,000/3,200 = $1.5625

7-8
Percent 15% 10% 30% 45% 100%
Machine-hours 320 160 1,120 1,600 3,200
Percent 10% 5% 35% 50% 100%
Direct costs $ 1,600 $ 5,500 $ 15,500 $ 13,400 $ 36,000
7-9
Phase 2, allocation of service department costs: whether, and to
what extent, reciprocal cost flows are recognized?
Three methods are used to allocate service department costs:

– The direct method
– The step method
– The reciprocal method
7-
Data for Beary Company
Cost before support

Dept cost allocation $5,850 $8,250 $24,750 $27,150
(from Phase 1)
Direct Method
• Allocates support costs only to operating departments.
• Direct method does not allocate support-department costs to other
support departments.
Phase 2: Direct Method
P-1 P-2 Total

S-1
Service % to production departments 30% 30%
Allocation % per direct method 50% 50%
Allocation amount $ 2,925 $ 2,925 $ 5,850
S-2
Service % to production departments 30% 60%
Allocation % per direct method 33.33% 66.67%
Allocation amount $ 2,750 $ 5,500 8,250
Plus Phase 1 Allocation Amount $ 24,750 $ 27,150 51,900
Total for Production Departments $ 30,425 $ 35,575 $ 66,000
7-13
P1 Department is using Direct Labor Hours (DLH) to allocate the cost

to product 1 and product 2
P2 Department is using Machine Hours (MH) to allocate the cost to
product 1 and product 2
7-14
Phase 3: Direct Method
Product 1 Product 2 Total
Labor-hours
Hours 1,800 1,800 3,600
Percent 50% 50%
Machine-hours
Hours 400 1,200 1,600
Percent 25% 75% Phase 2
P-1 (labor-hour basis) $ 15,212.50 $ 15,212.50 $ 30,425

P-2 (mahine-hour basis) 8,893.75 26,681.25 35,575
Totals for each product $ 24,106.25 $ 41,893.75 $ 66,000
7-15
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 that partially recognizes
the mutual services provided among all departments.
• Best practice to determine the sequence will be to choose support

department that gives the highest service to other service department
Cost before support

(from Phase 1)
Phase 2: Step Method
S-2 P-1 P-2 Total

Step 1--Allocation of S-1:
Service percent 40% 30% 30%
Amount $ 2,340 $ 1,755 $ 1,755 $ 5,850
Step 2--Allocation of S-2:
Service percent 30% 60%
Alloc. % per direct method 33.33% 66.67%
Amount $ 10,590 $ 3,530 $ 7,060 8,250
Plus: First-Phase Allocation 24,750 27,150 51,900
Totals $ 30,035 $ 35,965 $ 66,000
7-18
Phase 3: Step Method
Labor-hours
Hours 1,800 1,800 3,600
Percent 50% 50%
Machine-hours
Hours 400 1,200 1,600
Percent 25% 75%
Totals for each product $ 24,008.75 $ 41,991.25 $ 66,000
7-19
Reciprocal Method
• Allocates support-department costs to operating departments by fully
recognizing the mutual services provided among all support departments.
• Reciprocal method fully incorporates interdepartmental relationships into the
support-department cost allocation.
• Also known as the matrix method.
• An alternative way to implement the reciprocal method is to formulate and
solve linear equations. This implementation requires three steps.
Reciprocal Method (Linear Equations)
• The reciprocal method can also be implemented by formulating and
solving linear equations. This requires three steps:
1. Express Support Department Budgeted Costs and Reciprocal
Relationships in the form of linear equations.
2. Solve the set of linear equations to obtain the complete reciprocated
budgeted costs of each support department.
3. Allocate the complete reciprocated costs of each support department to
all other departments on the basis of the budgeted usage percentages.
Cost before support

(from Phase 1)
Step 1 : Linear equation to show Support dept cost and reciprocal relationship :
Allocated S1 Costs = Traceable Costs + Cost allocated from S2
S1 = $5,850 + (10% x S2)
Phase 2: Reciprocal Method (continued)
Step 11:and
Set2up andUp
: Set Solve
and Simultaneous Equations
Solve Simultaneous Equations
Allocated S1 Costs = Traceable Costs + Cost allocated from S2
S1 = $5,850 + (10% x S2)
Allocated S2 Costs = Initial allocation + Cost allocated from S1
S2 = $8,250 + (40% x S1)
The second equation is substituted into the first as follows:

S1 = $5,850 + 10% x [$8250 + (40% x S1)]
S1 = $6,953.13
Then the S1 figure is substituted into the second equation:
S2 = $8,250 + [40% x ($6,953.13)]
S2 = $11,031.25 7-23
Phase 2: Reciprocal Method (continued)
Second
Third Step: Allocation from Service Depts. To Prod. Departments
P-1 P-2 Total
S-1
Service % to prod. depts. 30% 30%
Allocated amount $ 2,086 $ 2,086 $6,953.13
S-2
Service % to prod. depts. 30% 60%
Allocated amount $ 3,309 $ 6,619 $11,031.25
Plus Phase-1 Allocation $ 24,750 $ 27,150
Totals $ 30,145 $ 35,855 $ 66,000
7-24
Phase 3: Reciprocal Method

Labor-hours
Hours 1,800 1,800 3,600
Percent 50% 50%
Machine-hours
Hours 400 1,200 1,600
Percent 25% 75%
Totals $ 24,036.25 $ 41,963.75 $ 66,000
7-25
Data for Robinson Company in 2017 (Exhibit 15-3)
Direct Method (Exhibit 15-4)
Step-Down Method (Exhibit 15-5)
Reciprocal Method (Exhibit 15-7)
Overview of Methods
• Differences among the three methods’ allocations increase as the magnitude
of the reciprocal allocations increases and as the differences across
operating departments’ usage of each support department’s services
increase.
• Direct and step-down are simple to compute and understand.
• Direct method is widely used but as computing power to perform repeated
iterations increases, more companies find the reciprocal method easier to
implement.
• Reciprocal is conceptually the most precise because it considers the mutual
services provided among all support departments
Bundled Products & Revenue Allocation Methods
• Revenue allocation occurs when revenues are related to a particular

REVENUE OBJECT but cannot be traced to it in an economically feasible
(cost-effective) way.
• Revenue object—anything for which a separate measurement of revenue is
desired.
• Allocation issues can arise when revenues from multiple products are
bundled together and sold at a single price
Allocate Revenue to Bundled Products: Stand-
Alone Method
Stand-alone (separate) revenue allocation method uses product-specific

information on the products in the bundle as weights for allocating the bundled
revenues to the individual products. Three types of weights may be used:
1. Selling prices
2. Unit costs
3. Physical units
Allocate Revenue to Bundled Products:
Incremental Revenue Method
Incremental revenue method ranks individual products in a bundle according to

criteria determined by management and then uses this ranking to allocate
bundled revenues to individual products.
 The first-ranked product is the primary product.

 The second-ranked product is the first incremental product.
 The third-ranked product is the second incremental product, and so on.
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Other Source : Cost Management 8th edition by Blocher et al., 2019

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Chapter 15

Allocation of Support- Department Costs,

• Operating (production) department—directly adds value to a product or

Department and Motivate managers to

Indirect labor cost rate = $25,000/12,000 = $2.0833

S-1 S-2 P-1 P-2 Total

Indirect material cost rate = $5,000/3,200 = $1.5625

Three methods are used to allocate service department costs:

Cost before support

P-1 P-2 Total

P1 Department is using Direct Labor Hours (DLH) to allocate the cost

P-1 (labor-hour basis) $ 15,212.50 $ 15,212.50 $ 30,425

• Best practice to determine the sequence will be to choose support

Cost before support

S-2 P-1 P-2 Total

Cost before support

The second equation is substituted into the first as follows:

Product 1 Product 2 Total

• Revenue allocation occurs when revenues are related to a particular

Stand-alone (separate) revenue allocation method uses product-specific

Incremental revenue method ranks individual products in a bundle according to

 The first-ranked product is the primary product.

Other Source : Cost Management 8th edition by Blocher et al., 2019

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