Manac II

Manac IITerm II PGP 18 Batch

Pankaj BaagFaculty Block 01, Room No 21

Mob: 8943716269 Ph (O): 0495-2809121Ext. 121Email: baagpankaj@iimk.ac.in

Chapter 15Allocation of Support-Department Costs, Common Costs, and RevenuesOverhead cost accounting, analysis and controlOverheads: Broadly, any expenditure incurred over and above prime costs.The total cost of indirect materials, indirect labour and indirect expenses.Indirect: that which cannot be allocated, but which can be apportioned to or absorbed by cost centers or cost units.Cost Allocation: The charging of discrete identifiable cost to cost centers or cost unitsCost apportionment: The division of costs amongst two or more cost centers in proportion to the estimated benefit received. Classification: Based on Functions, Elements, BehaviourFunctions: Production OH, Admn. OH, Selling & Distribution OHElements: Indirect Material, Indirect Labour, Indirect expensesBehaviour: Variable OH, Fixed OH, Semi-variable/semi-fixed OHBut, how to make effective analysis and control of the expensesWhat we doEach of the Production, Admn., S&D OH is classified into smaller sub-divisions.. to ensure that similar expenses by nature are grouped together under one head done through a suitable list of expenses headings. These headings are known as Standing Order Numbers for production OH, and Cost Account Numbers for Admn., and S&D OHMethod of compilation is same in each caseBut principles to be kept in mind are:Each is clearly defined, not to be confused with anotherEnough headings to cover every circumstanceShould not be narrow in scope as to allow some items of expense to fall into a somewhat similar headingAll these expense headings are given code numbers. Allocation of code numbers are done in many ways. But, the most two popular method are: the Mnemonic method and the Decimal method

the Mnemonic method : uses as code the letters of alphabet for easy memory. Eg AD for administration RE for repairs MA for maintenance SAL for salaries SA for salesThese letters may again be used in conjunction with numbersThe Decimal method : a system of numerical codesEG. Production OH: 08 Service Departments 08 01 Stores 02 Tool Room 03 Boiler Room 04 Canteen . Etc.

08 03 Boiler room 01 Stokers wages 02 coke 03 water 04 Depreciation 05 Maintenance. etcFor cost account numbers, entirely separate classification are made. But. The reference numbers should not conflict with that of Standing Order Numbers for Production OH. There should be enough gap.Admn. OH:45 Salaries45 01 Officers 02 Clerks 03 others45 01 Officers 01 MD 02 Accountant 03 Secretary.. etc

Similarly for S&D OH:75 salaries76 commissions77 advertisements78 Transport

75 salaries 01 salesman 02 sales managers 03 Travelers. etc 77 advertisements 01 Newspaper 02 Radioetc

Production OHThese are added to Prime costs,As these cannot be specifically related to cost centers/cost units, these are apportioned to various departments and then to the cost centers/cost unitsIt involves the following steps:Classification of OHCollection of OHDistribution of OH to production & service departmentsRedistribution of service department costs to the department using the servicesAbsorption of OH by production units

We have already discussed the classification. We now look into the other stepsCollection of OH:Production OH should be collected under separate Standing Order Numbers provided. Some of the documents used for this purpose are:Stores Requisitions : basically indirect materials are obtainedTime cards or wages analysis sheet: Indirect wages for each departmentInvoices/Purchase vouchersCash books: for petty expensesSubsidiary records: no cash outlay like depreciation, notional rent etc.

Distribution of OH to production & service departmentsThere are broadly two types of departments:Production department: where goods are producedService departments: which render services to production department. Eg. Stores, Repairs and maintenance, Inspection, purchase department, accounts, etc.

Allocating Costs of a Supporting Department to Operating DepartmentsSupporting (Service) Department provides the services that assist other internal departments in the company

Operating (Production) Department directly adds value to a product or service

Companies distinguish operating departments from support departments. Methods to Allocate Support Department CostsSingle-rate method allocates costs in each cost pool (service department) to cost objects (production departments) using the same rate per unit of a single allocation baseNo distinction is made between fixed and variable costs in this method Single-Rate method is simple to implement, but treats fixed costs in a manner similar to variable costs

Dual-Rate method segregates costs within each cost pool into two segments: a variable-cost pool and a fixed-cost pool. Each pool uses a different cost-allocation baseDual-Rate method treats fixed and variable costs more realistically, but is more complex to implement

Allocation BasesUnder either method, allocation of support costs can be based on one of the three following scenarios:Budgeted overhead rate and budgeted hoursBudgeted overhead rate and actual hoursActual overhead rate and actual hours

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

Costs are distributed to these departments on some estimated basis. This distribution process is known as Primary Distribution. It represents assigning, allocating or apportioning the OH costs to all the departments, divisions, cost centers to which it apply. This is also known as departmentalization. The following are some of the common bases (cost driver) used for primary distribution of Production OH:

Items of expenditureRent, Depreciation, insurance (building)Ins. & Dep. Of P & MPower

Heating & lightingElectricityBasis of distributionArea occupied

Capital valueHorse power * machine hrsFloor areaIf metered , directLight pointsProductionDepartmentsServiceDepartmentsCarry out the central purposesof an organization.

Provide supportthat facilitates theactivities of production departments.

Service Department Cost Allocationsupport

17-15First, we identify the factor that drives costs in theservice department.This cost driver is called the allocation base.How are servicedepartment costscharged to productiondepartments?

Service Department Cost Allocation17-16

Well, we measure theconsumption of theallocation base in theproduction departments.Service Department Cost AllocationHow are servicedepartment costscharged to productiondepartments?17-17

Third, we allocate the servicedepartment cost based on the relative amount of theallocation base consumed ineach production department. Service Department Cost AllocationHow are servicedepartment costscharged to productiondepartments?17-18

Allocated service departmentcosts become a part of themanufacturing overhead in each production department. Service Department Cost AllocationWhat happens toservice departmentcosts after they areallocated to production departments?17-19

Allocated service departmentcosts become a part of themanufacturing overhead in each production department. I get it. They becomea part of the overheadthat is applied toproducts with apredeterminedoverhead rate.Service Department Cost Allocation17-20

So, the costs become a part of the finished product via the application of the pre-determined factoryoverhead rate.Exactly. Take a look atthis flow chart.I think it will summarizeour discussion of theallocation process. Service Department Cost Allocation17-21Service Department(Cafeteria)Service Department(Accounting)Service Department(Personnel)ProductionDepartment(Machining)ProductionDepartment(Assembly)The ProductSecond Stage AllocationsProduction department overhead costs, plus allocated service department costs, are applied to products using departmental predetermined overhead rates.Service Department Cost AllocationFirst Stage AllocationsService department costs are allocated to production departments.17-22Selecting Allocation BasesPersonnel:Number ofemployeesReceiving:UnitshandledSecurity:SquarefootagePower:KilowatthoursCafeteria:Number ofemployeesCustodial:SquarefootageAccounting:StaffhoursTypicalAllocationBases17-23When allocating costs to departments, we want to assign a fair amount to the department that is using the service. Although sometimes there is no direct cause and effect relationship between the cost driver and the portion of the cost assigned to the department, we still try to look at appropriate drivers of the costs.

For example, an appropriate driver for assigning the costs of running the personnel department might be the total number of employees in each department, because, more employees required would seem to cause more costs for the personnel department. Another appropriate driver might be number of new hires by each department.

The costs of security or custodial services would seem to increase as the amount of space increases, so, the square footage of the department using these services may be an appropriate driver of the cost. Another appropriate driver might be the number of hours actually spent by security or custodians in each department.

Selecting Allocation BasesCriteria forselectionPersonnel:Number ofemployeesReceiving:UnitshandledSecurity:SquarefootagePower:KilowatthoursCafeteria:Number ofemployeesCustodial:SquarefootageAccounting:StaffhoursSimplicityAvailabilityof space orequipmentBenefits receivedby the productiondepartment 17-25Sometimes, different services will have the same , or similar, cost driving characteristics. In this case, both personnel department and cafeteria costs seem to be driven by the number of employees. In these cases it is possible to simplify our allocations by pooling these costs. To do so, we would combine the total costs of running personnel and the cafeteria, then allocate those costs using the same basis.

Custodial and security costs are driven by the amount of square footage of property occupied. It is appropriate to pool these costs.

The costs of the service departments are assigned to the user departments in proportion to the benefits received by the user department.

See problem 1One problem that accountants face when allocating is, that one service department might supply services to another service department, and indeed, may actually consume some of its own services.

An example might be the power department that supplies electricity to service departments, production departments, and, even consumes some of its own electricity.

Interdepartmental ServicesService Department(Cafeteria)Service Department(Custodial)ProductionDepartment(Machining)ProductionDepartment(Assembly)POWER DEPARTMENT17-28Redistribution of service department costs to the department using the servicesAs the OH expenses are ultimately to be charged to cost units, the service department costs are therefore redistributed to the production department where the production is going on.This process of apportionment of OH expenses is known as Secondary Distribution. Here also there are items and basis of distribution (cost Driver)Eg. For inspection inspection hours spent Purchase -- No of orders, or quantity or value Repairs -- hours worked; asset value * hours worked Time keeping -- No. of employees; labour hrs; machine hrs Accounts -- No. of workers.. Etc. But how do you redistribute

Methods of Redistribution:Direct redistributionStep methodReciprocal services method

Reciprocal is the most precise

Direct and Step-Down are simple to compute and understand

Direct Method is widely usedUnder the direct method, each service departments costs are allocated among only the departments that consume part of the service departments output. This method ignores the fact that some service departments provide services to other service departments. Thus, even though one department might provide services to two other service departments, none of its costs are allocated to those departments.

Allocates support costs only to Operating Departments

No Interaction between Support Departments prior to allocation

Direct Redistribution MethodService Department(Cafeteria)Service Department(Custodial)ProductionDepartment(Machining)ProductionDepartment(Assembly)Cost of servicesbetween servicedepartments areignored and allcosts areallocated directlyto productiondepartments.

For an example please see problem 2.17-33As stated previously, the direct method ignores the provision of services by one service department to another service department. This shortcoming is overcome partially by the step-down method of service department cost allocation. Under this method, the managerial accountant first chooses a sequence in which to allocate the service costs.A common way to select the first service department in the sequence is to choose the one that serves the largest number of other service departments. The departments are ordered in this manner, with the last service department being the one that serves the smallest number of other service departments.

Then the managerial accountant allocates each service departments costs among the custodial and all of the other service departments that follow it in the sequence. Once a service departments costs have been allocated, no further costs are assigned to that department.Note that the ultimate cost allocations assigned to the Assembly and Machining departments will differ depending on the sequence chosen.Once the cost of the cafeteria is allocated, the custodial department then assigns its costs to the production departmentsHere, the fact that many services department may render reciprocal services is ignored. As a result, the total cost of a service department cannot be accurately ascertained although it will not distort the final charges to the production department.

Allocates support costs to other support departments and to operating departments that partially recognizes the mutual services provided among all support departmentsOne-Way Interaction between Support Departments prior to allocation

Step MethodService Department(Cafeteria)Service Department(Custodial)ProductionDepartment(Machining)ProductionDepartment(Assembly)Service departmentcosts are allocatedto other servicedepartments andto productiondepartments, usuallystarting with theservice departmentthat serves thelargest number of other service departments. 17-37Step MethodService Department(Cafeteria)Service Department(Custodial)ProductionDepartment(Machining)ProductionDepartment(Assembly)Once a servicedepartments costsare allocated, other servicedepartments costsare not allocatedback to it. 17-38Step MethodService Department(Cafeteria)Service Department(Custodial)ProductionDepartment(Machining)ProductionDepartment(Assembly)Custodial willhave a newtotal to allocateto productiondepartments: itsown costs plusthose costsallocated fromthe cafeteria. For an example please see problem 3.17-39