© 2012 McGraw-Hill Education (Asia)
Cost Allocation
Chapter 6
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 2
Cost Allocation and Charges for Services Rendered
Intracompany – inside the same entity
This chapter will coverreasons for establishment of an internal service
charging system or to have an cost allocation system
techniques and principles of allocation to be used
allocation of service department costs to operating departments using the direct and step-down methods
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 3
Cost Allocation and Charges for Services Rendered Intercompany – different entities within the same
group
Transfer pricing may help group’s tax planning may be monitored and scrutinized by tax authorities
and other interested regulating bodies/agents. needs to be seen as an “arm’s length transaction”
Will be covered in Chapter 13 Appendix A
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 4
Learning Objective 1
Explain the major reasons for Explain the major reasons for the need for allocating the need for allocating
nonmanufacturing costs.nonmanufacturing costs.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 5
Service Department Charges
Operating Departments
Carry out central purposes of organization.
Service Departments
Do not directly engage in operating activities.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 6
Reasons for Charging Service Department Costs
To encourage operating departments to wisely use service
department resources.
To encourage operating departments to wisely use service
department resources.
To provide operating departments with
more complete cost data for making
decisions.
To provide operating departments with
more complete cost data for making
decisions.
To help measure the profitability of
operating departments.
To help measure the profitability of
operating departments.
To create an incentive for service
departments to operate efficiently.
To create an incentive for service
departments to operate efficiently.
Service department costs are charged to operating departments for a variety of reasons including:
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 7
Management Needs Need to understand the full cost of providing a
product or service (including supporting costs) to make better decision.
• Ensuring competitive costing and pricing • Assessment of risk and potential success of
the product/service• Financial and operational forecasts and
planning• Motivating performance evaluation and
reward system• Communicating to employees about the
importance of recovering all indirect costs• Encouraging efficient and effective use of
resources • Ensuring long-term sustainability and
competitiveness
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 8
$
Transfer Prices
OperatingDepartments
ServiceDepartments
The service department charges considered can be viewed as a transfer
price that is charged for services provided by service departments to operating departments/companies
within the group.
The service department charges considered can be viewed as a transfer
price that is charged for services provided by service departments to operating departments/companies
within the group.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 9
Factors To Be Considered For The Cost Allocation Approach and Intercompany/Interdepartmental charges
Cost-benefit Evaluation • Including tangible and intangible costs and benefits
Cause and effect• Absorption of cost based on who causes it
Benefit Received• Absorption of cost based on the ultimate benefactor
Ability to Bear• Absorption of cost based on who/which product has
the ability and profit margin to bear the cost Fairness or Equity
• Ensuring fair game and decent profit to motive service provider, for example, use of a cost-plus performance based award fee approach, to ensure quality delivery of service/product
© 2012 McGraw-Hill Education (Asia)
Service Department Charges
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 11
Learning Objective 2
Allocate costs of service Allocate costs of service departments to other operating departments to other operating
departments/units using the cost departments/units using the cost behavior concept.behavior concept.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 12
Charging Costs by Behavior
Whenever possible,variable and fixed
service department costsshould be charged
separately.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 13
Variable servicedepartment costs should be
charged to consuming departmentsaccording to whatever activity
causes the incurrence of the cost.
Charging Costs by Behavior
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 14
Charge fixed service department costs to consuming departments in predetermined lump-sum amounts that are based on the consuming department’s peak-period or
long-run average servicing needs.
Charge fixed service department costs to consuming departments in predetermined lump-sum amounts that are based on the consuming department’s peak-period or
long-run average servicing needs.
Are based on amounts ofcapacity each consuming
department requires.
Should not vary fromperiod to period.
Charging Costs by Behavior
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 15
Should Actual or Budgeted Costs Be Charged?
Budgeted variableand fixed service departmentcosts should be charged to
operating departments.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 16
Sipco has a maintenance department and two operatingdepartments: Cutting and Assembly. Variable maintenance
costs are budgeted at $0.60 per machine hour. Fixedmaintenance costs are budgeted at $200,000 per year.
Data relating to the current year are:
Allocate maintenance costs to the two operating departments.
Sipco: An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 17
Actual hours
Sipco: End of the Year
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 18
Percent of peak-period capacity.
Sipco: End of the Year
Actual hours
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 19
Quick Check Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable ambulance costs are budgeted at $4.20 per mile. Fixed ambulance costs are budgeted at $120,000
per year. Data relating to the current year are:
Percent ofPeak-Period Capacity Miles Miles
Hospitals Required Planned UsedMercy 45% 15,000 16,000 Northside 55% 17,000 17,500 Total 100% 32,000 33,500
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 20
Quick Check
How much ambulance service cost will be allocated to Mercy Hospital at the end of the year?a. $121,200b. $254,400c. $139,500d. $117,000
How much ambulance service cost will be allocated to Mercy Hospital at the end of the year?a. $121,200b. $254,400c. $139,500d. $117,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 21
How much ambulance service cost will be allocated to Mercy Hospital at the end of the year?a. $121,200b. $254,400c. $139,500d. $117,000
How much ambulance service cost will be allocated to Mercy Hospital at the end of the year?a. $121,200b. $254,400c. $139,500d. $117,000
Quick Check
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 22
Allocating fixed costs using a variable
allocation base.
Pitfalls in Allocating Fixed Costs
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 23
Using salesdollars as an
allocation base.
Pitfalls in Allocating Fixed Costs
Result
Sales of one departmentinfluence the service
department costsallocated to other
departments.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 24
Autos R Us – An Example
Autos R Us has one service department and three sales departments, New Cars, Used Cars, and Car Parts. The service department costs total $80,000
for both years in the example. Contrary to good practice, Autos R Us allocates the
service department costs based on sales.
Autos R Us has one service department and three sales departments, New Cars, Used Cars, and Car Parts. The service department costs total $80,000
for both years in the example. Contrary to good practice, Autos R Us allocates the
service department costs based on sales.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 25
Autos R Us – First-year Allocation
New Used Parts TotalSales by department 1,500,000$ 900,000$ 600,000$ 3,000,000$ Percentage of total sales 50% 30% 20% 100%Allocation of service department costs 40,000$ 24,000$ 16,000$ 80,000$
Departments
$1,500,000 ÷ $3,000,000 50% of $80,000
In the next year, the manager of the New Cars departmentincreases sales by $500,000. Sales in the other departments
are unchanged. Let’s allocate the $80,000 service departmentcost for the second year given the sales increase.
In the next year, the manager of the New Cars departmentincreases sales by $500,000. Sales in the other departments
are unchanged. Let’s allocate the $80,000 service departmentcost for the second year given the sales increase.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 26
Autos R Us – Second-year Allocation
New Used Parts TotalSales by department 2,000,000$ 900,000$ 600,000$ 3,500,000$ Percentage of total sales 57% 26% 17% 100%Allocation of service department costs 45,714$ 20,571$ 13,714$ 80,000$
Departments
$2,000,000 ÷ $3,500,000 57% of $80,000
If you were the manager of the New Cars department, wouldyou be happy with the increased service department
costs allocated to your department?
If you were the manager of the New Cars department, wouldyou be happy with the increased service department
costs allocated to your department?
© 2012 McGraw-Hill Education (Asia)
Service Department Allocations
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 28
Operating Departments
An operating department carries out the central purpose of the organization
An operating department carries out the central purpose of the organization
The Surgery Department
at Mount Sinai
Hospital.
The Surgery Department
at Mount Sinai
Hospital.
A Production Department
at Mitsubishi.
A Production Department
at Mitsubishi.
The Geography Department
at the University of Washington.
The Geography Department
at the University of Washington.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 29
Service Departments
Service departments do not directly engage in operating activities.
Service departments do not directly engage in operating activities.
The Accounting Department at Macy’s.
The Accounting Department at Macy’s.
The Human Resources Department
at Walgreens.
The Human Resources Department
at Walgreens.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 30
Interdepartmental Services
ServiceDepartment
OperatingDepartment
Costs of the service department become overhead costs to
the operating department
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 31
Allocation Approaches
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 32
Reciprocal Services
ServiceDepartment 1
ServiceDepartment 2
When service departments provide
services to each other we call them
reciprocal services.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 33
Learning Objective 3
Allocate service Allocate service department costs to department costs to
operating departments operating departments using the direct method.using the direct method.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 34
Direct Method
Service Department(Cafeteria)
Service Department(Custodial)
Operating Department(Machining)
Operating Department(Assembly)
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 35
Direct Method – An Example
Service Department Allocation Base
Cafeteria Number of employeesCustodial Square feet occupied
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 36
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?
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 37
Direct Method – An Example
Allocation base: Number of employees Allocation base: Number of employees
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 38
Direct Method – An Example
Allocation base: Number of employees
$360,000 ×30
20 + 30= $216,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 39
Direct Method – An Example
Allocation base: Square feet occupied Allocation base: Square feet occupied
$90,000 ×25,000
25,000 + 50,000 = $30,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 40
Direct Method – An Example
Allocation base: Square feet occupied Allocation base: Square feet occupied
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 41
Learning Objective 4
To allocate service To allocate service department costs to department costs to
operating departments operating departments using the step-down using the step-down
method.method.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 42
Operating Department(Machining)
Operating Department(Assembly)
Step-Down Method
Once a servicedepartment’s costs
are allocated, other service
department costsare not allocated
back to it.
Service Department(Cafeteria)
Service Department(Custodial)
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 43
There are three key points to understand regarding the step-down method: In both the direct and step-down methods, any
amount of the allocation base attributable to the
service department whose cost is being allocated is
always ignored.
Any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored.
Each service department assigns its own costs to operating departments plus the costs that have been allocated to it from other service departments.
Step-Down Method
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 44
Service Department Allocation Base
Cafeteria Number of employeesCustodial Square feet occupied
We will use the same data used in the direct method example.
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 45
Allocate Cafeteria costs first sinceit provides more service than Custodial.
Allocate Cafeteria costs first sinceit provides more service than Custodial.
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 46
$360,000 ×10
10 + 20 + 30= $60,000
Allocation base: Number of employees Allocation base: Number of employees
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 47
$360,000 ×20
10 + 20 + 30= $120,000
Allocation base: Number of employees Allocation base: Number of employees
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 48
$360,000 ×30
10 + 20 + 30= $180,000
Allocation base: Number of employees Allocation base: Number of employees
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 49
New total = $90,000 original Custodial cost plus $60,000 allocated from the Cafeteria.
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 50
$150,000 ×25,000
25,000 + 50,000 = $50,000
Allocation base: Square feet occupied Allocation base: Square feet occupied
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 51
$150,000 ×50,000
25,000 + 50,000 = $100,000
Allocation base: Square feet occupied Allocation base: Square feet occupied
Step-Down Method – An Example
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 52
Reciprocal Method
Interdepartmentalservices are given
full recognitionrather than partialrecognition as withthe step method.
Service Department(Cafeteria)
Service Department(Custodial)
Operating Department(Machining)
Operating Department(Assembly)
Because of its mathematical complexity, the reciprocal method is rarely used.
Because of its mathematical complexity, the reciprocal method is rarely used.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 53
Quick Check Datafor Direct and Step-Down Methods
Allocation bases:Business school administration costs (ADMIN): Number of employees
Business Administration computer services (BACS): Number of personal computers
The direct method of allocation is used.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 54
Quick Check
How much cost will be allocated from Administration to Accounting?a. $ 36,000b. $144,000c. $180,000d. $ 27,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 55
How much cost will be allocated from Administration to Accounting?
a. $ 36,000b. $144,000c. $180,000d. $ 27,000
Quick Check
$180,000 ×20
20 + 80= $36,000
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 56
Quick Check
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $ 52,500b. $135,000c. $270,000d. $ 49,500
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 57
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $ 52,500b. $135,000c. $270,000d. $ 49,500
Quick Check
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 58
Quick Check Data
Allocation bases:Business school administration costs (ADMIN): Number of employees
Business administration computer services (BACS): Number of personal computers
Allocation bases:Business school administration costs (ADMIN): Number of employees
Business administration computer services (BACS): Number of personal computers
The step method of allocation is used.
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 59
Quick Check
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $35,250b. $49,072c. $18,000d. $26,333
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 60
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?a. $35,250b. $49,072c. $18,000d. $26,333
Quick Check
McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & YuenMcGraw-Hill/Irwin Slide 61
End of Chapter 6