Support Department Cost

Allocation
Topic 2

ACCT 2160 Cost Analysis and Applications

 Topic Objectives

• Understand the nature of support departments and

how these costs are allocated to the operating
departments
• Understand why dual rates should be used to
allocate support department costs
• Understand when actual or budgeted usage of
support departments should be used to allocate costs
• Understand why budgeted (not actual) support
department costs should be allocated
• Be able to allocate support department costs using
the 3 allocation methods
• Understand the differences between the 3 methods

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 Service and Production
Department Cost Allocation

Production Service
Departments Departments

Carry out the Provide support

central purposes that facilitates the
of an organization. activities of user
departments.
 What is a support department

 Production costs are not the only costs required to produce a product or
service
 Many non-production activities are required to support the production of
products and services. For example
 Finance
 Personnel Management
 Computing services
 Engineering
 Maintenance
 Cleaning
 Even the Cafeteria!

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 Why allocate support department costs?

1. To provide information to support decision-making in

relation to the use of support activities

2. To provide information to help department managers

understand the economic consequences of their
decisions regarding support services

3. To provide information to motivate department

managers and other employees to manage support
department costs more effectively

4. To provide information for evaluating responsibility

centre and/or manager performance

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 Allocation of support department costs

• Support department costs need to be allocated to the cost objects that cause
those costs
o These cost objects include -
• Other departments that use support services
• And ultimately, products or services

• Why allocate these costs?

o Remember the uses for cost allocations from earlier?

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 What happens to support department costs?

What happens to
service department Allocated service department
costs after they are costs become a part of the
allocated to production manufacturing overhead in
departments? each production department.

If manager’s are evaluated

and rewarded on financial
performance this has to be a
meaningful exercise
otherwise there will be
heated debates about
allocation methods applied
 What are the issues?

Five (5) issues in allocating support department costs

1.Which allocation bases should be used to allocate
support department costs?
2.Should single or dual rates be used?
3.Should budgeted or actual usage of support departments
be used to allocate costs
4.Should budgeted or actual support department costs be
allocated?
5.When there are multiple departments, which method of
allocating support department costs should be used

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 Issue 1: Choosing Cost Drivers for Allocation Bases

Common Cost Typical Allocation Base

Category Example for Common Cost
Occupancy Building rental Space occupied
Related Building insurance Space occupied
Heat & A/C Space or volume occupied
Concession rental Space occupied
Desirability of location
Building Maintenance Space occupied
Service Materials Handling Quantity or value of materials
Related Laundry Weight of laundry processed
Billing and accounting Number of documents
Indirect materials Value of direct materials
Cafeteria Number of meals

Recall Cause-and-Effect Criterion … these

factors are the causes of the costs and cost
drivers become the allocation bases ...
 Issue 2: Single or dual allocation rates for
variable and fixed costs
 Should variable and fixed support department costs be allocated -
◦ Together in one cost pool – single rate?
◦ Separately in two cost pools – dual rate?

 One cost pool

◦ Uses only one allocation base
◦ Therefore assumes variable and fixed costs have the same cause
◦ Is this reasonable? – Sometimes fixed costs can be incorrectly allocated
(over or under-allocated if a single rate is used)

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 Allocate costs to departments using dual
rates

• Fixed Costs are incurred to provide support departments with

the ability to satisfy the demands of the operating departments
in the long-term
– In any given month operating departments may not use all a support
department’s capacity available
– However over time it is assumed they will

• Therefore long-term average usage of support departments

is likely to represent the “cause” of Fixed Costs
– “Average actual capacity” or “Practical capacity”

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 When allocating costs to departments using
dual rates

• Using Dual Rates:

• Need to determine allocation ratios (allocation bases) for each operating
department based on practical capacity proportions (i.e. total capacity
utilised by each department out of 100% - Dept 1 = 45%; Dept 2 =
55%)
• Fixed costs will not be “unitised” when allocation base ratios are used to allocate
fixed costs
– Ratios stay constant until long-term capacity changes
• Ultimately dual rates provide more accurate support department cost allocation
as they use the “cause and effect” rule

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 Issue 3: Budgeted or actual usage of support
departments?

• Should support department costs be allocated based on budgeted or actual usage of

allocation base?
– It depends on the purpose of the allocation

• Purpose is budgeting or planning?

– Use budgeted usage so that allocations can be done at the beginning of the
period

• Purpose: evaluation of department manager performance?

– Actual usage should be used as this most accurately represents the outcome of
managers decisions regarding support usage

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 Issue 4: Budgeted versus actual cost allocation

The Issue
• Should actual or budgeted support department costs be
allocated to operating departments?
The answer?
• Budgeted costs should be allocated for two main reasons
1. It allows allocation of support department costs during the
period – more timely information
2. It provides more equitable information for the evaluation of
operating and support department managers

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 Allocation of budgeted costs –
provides more timely information
If budgeted costs are allocated -
• Application rates can be determined at the start of the period
– Jobs/products can be costed during the period
– Managers can budget for the cost of using support department resources
– i.e. They will know that the variable cost rate to include

• Conversely actual costs are not known until the end of the
period, therefore actual cost allocations will not provide
timely information

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 Allocation of budgeted costs –
equitable performance evaluation

General rule of manager performance evaluation

• Managers should only be held responsible for
costs/activities over which they have control

• Operating department managers usually have substantial

control over the level of support department services
required
– Therefore support department costs should be allocated but…..

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 Allocation budgeted costs –equitable
performance evaluation
• But..... operating department managers do not usually have
complete control over
– the amount of resources used by support department to provide service
– Costs incurred by support department to provide those services

• These factors are influenced by the efficiency of the support

department in providing its services
– I.e. did the support department;
– use too many resources to provide service required?
– Incur unreasonably high costs to provide service?

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Summary Separate Fixed and Variable
Costs: Dual Allocation

Variable Fixed
Costs Costs

Allocate
Charge to user
budgeted amounts
departments at a
to user departments
budgeted rate times
in proportion to the
the actual usage of
capacity demanded by
the allocation base.
the user department.
Budgeted costs should be allocated
to avoid passing on inefficiencies
from the service departments.
 Issue 5: What if there is more than one
support department?

• Possible Allocation Methods when multiple support departments exist:

1. Direct Method
2. Sequential (step down) Method
3. Reciprocal Method
• If multiple support departments exist, they are likely to interact
– i.e. Supply services to each other as well as to operating departments
• The most accurate cost allocation takes into account these “reciprocal”
sharing of services

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 Multiple Support Departments and
Provision of Support Services

Support Department Support Department

(Admin) (Housekeeping)

Allocation Allocation
method? method?

Medical Dept Dental Dept

Arrows represent services provided by Support Departments to

other departments
Services provided to Support Departments
Services provided to Operating Departments
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1. Direct Method

Service Production
Department Department
Cost of services (Admin) (Medical)
between service
departments are
ignored and all
costs are
allocated directly
to user Service Production
departments. Department Department
(Housekeeping) (Dental)
 2. Step Method

Service department Service Production

costs are allocated Department Department
(Admin) (Medical)
to other service
departments and
to production
departments, usually
starting with the
service department Service Production
that provides the Department Department
greatest amount of (Housekeeping) (Dental)
service to other
departments.
 2. Step Method

Service Production
Department Department
Once a service (Admin) (Medical)
department’s costs
are allocated,
other service
department costs
are not allocated
Service Production
back to it.
Department Department
(Housekeeping) (Dental)
2. Step Method

Service Production
Department Department
Custodial will (Admin) (Medical)
have a new
total to allocate
to production
departments: its
own costs plus
Service Production
those costs
Department Department
allocated from (Housekeeping) (Dental)
the cafeteria.
3. Reciprocal Method

Service Production
Department Department
(Admin) (Medical)
Interdepartmental
services are given
full recognition
rather than partial
recognition as with
the step method. Service Production
Department Department
(Housekeeping) (Dental)
 3. Reciprocal Method

• Start with equations that represent TOTAL support department costs – as if

support department allocations had occurred

• Use simultaneous equations to determine the cost

allocations required to reflect these interactions
• The cost equation for each support department can be expressed as follows:

SD1 = Direct costs + Share of SD2’s cost

SD2 = Direct costs + Share of SD1’s costs
• Then substitute as per simultaneous equations

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 Comparison of Methods

• Note: If allocations results are similar between methods

– Usually this is a result of very few support departments, and/or
– the interactions between the support departments are relatively small

• Choice of method should be based on cost-benefit

– Benefit to allocation accuracy vs. costs of method
– See tutorial questions for a greater analysis of this issue

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