Allocation of Support Department Costs, Common Costs, and Revenues

1
Chapter 15

• Allocation of Support DepartmentCosts, Common
  Costs, and Revenues
• CCs 15-29 (8) (new)
• 15-37 (10) (11.15-36)

2
Cost allocation what it means

• Some production centers or departments provide
  output required by other production centers
  (Service departments).
• The costs of these departments are allocated to
  the internal users according to use and add to
  their costs
• so the costs of service departments providing
  these products and services go indirectly into
  the cost of saleable output
• Service departments costs are allocated using
  the actual utilization volume times an allocation
  rate per unit

3
Allocating Support Departments Costs

• An operating department (a production department
  in manufacturing companies) adds value to a
  product or service
• A support department (service department)
  provides the services that assist other operating
  and support departments in the organization.

4
Structure of Service Department Cost Attribution
Attribution to cost pools of the centers each
activity has exactly one cost driver
Support departments
Secondary Activities
Usage ? cost driver rate
Reciprocal services
Operating departments
Primary Activities
Product 1
?
(Traceable costs)
Product n
5
Single-Rate and Dual-Rate Methods

• The single-rate cost allocation method pools
  together all costs in a cost pool.
• The dual-rate cost allocation method classifies
  costs in each cost pool into two cost pools
• a variable-cost cost pool and
• a fixed-cost cost pool
• Organizations commit to infrastructure costs on
  the basis of a long-run planning horizon.
• Budgeted rates let the user department know in
  advance the cost rates they will be charged
• During the budget period, the supplier
  department, not the user departments, bears the
  risk of any unfavorable cost variances.
• When actual rates are used for cost allocation,
  managers do not know the rates to be used until
  the end of the budget period
• The use of budgeted usage to allocate these fixed
  costs is consistent with the long-run horizon.

6
Allocating Support Departments Costs

• Direct method
• Allocates support department costs to operating
  departments only.
• Step-down (sequential allocation) method
• Allocates support department costs to other
  support departments and to operating departments
• charge rates are calculated for support
  departments according to a rank order. Those
  departments rank highest that get the least from
  other departments
• at each step support is charged only from the
  departments whose charge rate has already been
  calculated
• Reciprocal allocation method
• Allocates costs by services provided among all
  support departments
• simultaneous equations approach

7
Example

• The Canton Division of Smith Corporation has two
  operating departments
• Assembly and Finishing
• and two support departments
• Maintenance
• allocated using square feet.
• Total square feet 255,000
• Human Resources
• allocated using number of employees
• Total number of employees 95

Maintenance Human
Resources Assembly Finishing Budgeted costs
before allocations 300,000 2,160,000 1,
700,000 900,000 Square feet 5,000
30,000 110,000 110,000
of employees 8 15
48 27
8
Direct Method
Support Departments
Operating Departments
1,700,000 Assembly
Maintenance 300,000
110/220
0
0
110/220
48/72
900,000 Finishing
Human Resources 2,160,000
24/72
Assembly Finishing Original
costs 1,700,000 900,000 Maintenance
Allocated 150,000
150,000 Human Resources Allocated 1,440,000
720,000 Total 3,290,000 1,770,000
9
Step-Down Method

• Which support department should be allocated
  first?
• Maintenance provides 12 of its services to Human
  Resources.
• Human Resources provides 10 of its services to
  Maintenance.
• Maintenance to Human Resources
• 12 300,000 36,000
• Maintenance to Assembly 44 300,000
  132,000
• Maintenance to Finishing 44 300,000
  132,000
• Human Resources costs to be allocated become
• 2,160,000 36,000 2,196,000
• Human Resources to Assembly 48 72 2,196,000
  1,464,000
• Human Resources to Finishing 24 72
  2,196,000
• 732,000

10
Overhead Allocation Sheet (Step down method)
xij aijxij usage of i by j
Secondary activities j does not use gt j
Primary activities
Traceable costs
One line for each kind of input used. Entries in
each line sum up to the respective amount in
the cost recording column
j 1 j 2 j 3
Costs from general ledger additional non-out-o
f- pocket cost S1 S2 S3
p1 x12 p1 x13
p2 x23
Sum of row i Si
... p3 x3j ...
S1 S2 S3 Sj
Total cost driver volume, center j
Sum of column j total cost of center j
x1 x2 x3 x3
p2 p3 p3
Cost driver rate
p1 S1 /x1
Start
Cost driver rates
11
Reciprocal
M HR A F Maintenance
12 44 44 Human Resources 10
60 30
Total Cost(j) traceable cost (j) S aij
Total cost(i) all i
where aij denotes js share of total is service
10 M HR 3,000,000 0.12 M HR
2,160,000 9.88 M 5,160,000 M 5,160.000 /
9.88 522,267 HR 2,160,000 0.12 522,267
2,222,672
M 300,000 0.10 HR HR 2,160,000 0.12 M
M 0.10 HR 300,000 0.12 M HR
2,160,000
12
Reciprocal
M HR A F Before allocation 300
,000 2,160,000 1,700,000
900,000 Allocation (522,267) 62,672
229,797 229,797 Allocation
222,267 (2,222,672) 1,333,603
666,802 Total 3,263,400 1,796,599 Tot
al cost Assembly Department 3,263,400 Total
cost Finishing Department 1,796,599
13
Budgeting requirements (contd)

• Then the total volumes of cost drivers are
  determined by the system of equations
• The same system can be written as a matrix
  equation

(One equation for each secondary activity i)
(I A)x y
14
Cost driver rates pi

• Activity account balance

Activity j
Traceable costs KPj
Service delivered pj xj
?
Cost of secondary activities
?
?
?
kPj
(I AT)p k
15
Example Fall River Company)

• Service centers Power Department, Water
  Department Production centers Divisions 1 und
  2.
• Data

Activity account balances 240 p1 20 p1 30
p2 4.9 220 p1 30 p2 4.9 160 p2 70
p1 10 p2 1.25 70 p1 150 p2 1.25
?
) Kaplan/Atkinson, Advanced Management
Accounting, 3rd ed. p.74-76 and 80-81. Numbers
modified.
16
Calculationdirect solution matrix calculus
220 p1 30 p2 4.9 5 70 p1
150 p2 1.25
1100 p1 150 p2 24.5 70 p1 150 p2
1.25

1030 p1 25.75
p1 0.025
1.751.25 150
p2 0.02
Power and water cost Div. 1 3.4 mill., Div. 2
2.75 mill.
17
Why the matrix calculus is useful

• The numerical data required are provided in the
  accounting data base and can automatically
  downloaded into the matrix A and a vector of
  traceable unit costs kP.
• Spreadsheet software usually offers the function
  of matrix inversion
• so the cost driver rates can be determined
  automatically.

18
Interpretation of R(I - A)-1

• Consider the equation for required total output
  of service i as a function of external
  requirements y
• xi (y) Sj rij yj
• Differentiate this function w.r.t. yj . You get
• rij
• This means rij represents the additional total
  output of service i required per additional unit
  of external output requirement of service j.
• Therefore the matrix R is sometimes called the
  total requirement matrix)

? xi (y) ? yj
19
Interpretation of R(I - A)-1

• In particular
• If you purchase one unit of the service i
  externally (reduce external demand by one unit)
• then you need rii units less to be procured
  internally.
• Or, in other words if you reduce internal
  pro-curement of the service by one unit, you need
  to buy only 1/ rii units from an external source.
  
• Since the function xi (y) is linear, this is
  globally true.

20
Interpretation of R(I - A)-1

• This means
• If you close down service center i then you
• can save the total reciprocal cost pi xi for this
  center
• must procure xi / rii units of the service
  externally
• You will break even if the external procurement
  price pi satisfies
• pi xi / rii pi xi
• i.e. you may pay at most an external price of
• pi pi rii

21
Interpretation of RT (I - AT)-1

• So we get the reciprocal cost per unit as a
  function of the traceable cost
• cj (kP) Si kiP rij
• Similarly to the above rij

? cj (kP) ? kiP
22
Reciprocal method Extension

• Dual rate system for assigning committed costs
  Peak load pricing
• Assigning
• committed cost according to capacity reservations
  by users
• flexible cost according to actual usage
• if a service is outsourced
• reciprocal method shows the effect on required
  total volume (capacity) of cost drivers for all
  service departments

23
Allocating Common Costs

• Two methods for allocating common cost
• Stand-alone cost allocation method
• actual cost is allocated in the ratio of
  stand-alone costs
• Incremental cost allocation method
• a sequence of cost objects is defined
• each object bears the incremental cost according
  to the sequence
• Shapley Value
• the average of incremental costs over all
  possible sequences is charged to the object
• the Shapley Value can be justified based on a set
  of plausible axioms

24
Example

• A consultant in Tampa is planning to go to
  Chicago and meet with an international client.
• The round-trip Tampa/Chicago/Tampa airfare costs
  540.
• The consultant is also planning to attend a
  business meeting with a North Carolina client in
  Durham.
• The round-trip Tampa/Durham/Tampa airfare costs
  360.
• The consultant decides to combine the two trips
  into a Tampa/Durham/Chicago/Tampa itinerary that
  will cost 760.
• Stand-alone method
• Cost for international client 760 540/(540
  360) 456
• Cost for North Carolina client 760 360/(540
  360) 304
• Incremental method, international client first
• Cost for international client 540
• Cost for North Carolina client 760 540 220
• Shapley Value 540 360
• 220 400
• 760/2 760/2

25
Revenues and Bundled Products

• A bundled product is a package of two or more
  products (or services) sold for a single price.
  Bundled product sales are also referred to as
  suite sales. The individual components of the
  bundle also may be sold as separate items at
  their own stand-alone prices.
• Examples

Banks
Hotels
Tours

• Checking
• Safety deposit boxes
• Investment advisory

• Lodging
• Food and beverage services
• Recreation

• Transportation
• Lodging
• Guides

26
Revenue Allocation Methods

• English Languages Institute buys English language
  software programs locally and then sells them in
  Mexico and Central America
• English sells the following programs Grammar,
  Translation, and Composition
• These programs are offered stand-alone or in a
  bundle

Stand-alone Unit Price Cost Grammar
255 180 Translation 85
45 Composition 185 95
Bundle (Suites) Price Grammar
Translation 290 Grammar Composition 35
0 Grammar Translation Composition 410
27
Revenue Allocation Methods

• The two main revenue allocation methods
• The stand-alone method with alternative weights
• Selling prices
• Unit costs
• Physical units
• Stand-alone product revenues
• The incremental method with alternative sequences

28
Stand-Alone RevenueAllocation Method

• Consider the Grammar and Translation suite, which
  sells for 290 per copy.
• 1a) Grammar 290 255/(255 85) 217.50
• Translation 290 85/(255 85) 72.50
• 1b) Grammar 290 180/(180 45) 232
• Translation 290 45/(180 45) 58
• 1c) Grammar 290/2 145
• Translation 290/2 145
• 1d) Assume that the stand-alone revenues in 2003
  
• Grammar 734,400 Translation 81,600,
  Composition 133,200.
• Grammar 734,400 816,000 0.90, 290
  0.90 261
• Translation 81,600 816,000 0.10, 290
  0.10 29

29
Incremental RevenueAllocation Method

• The first-ranked product is termed the primary
  product in the bundle
• If the suite selling price exceeds the
  stand-alone price of the primary product, the
  primary product is allocated 100 of its
  stand-alone revenue.
• The second-ranked product is termed the first
  incremental product
• The third-ranked product is the second
  incremental product, and so on.
• Assume that Grammar is designated as the primary
  product
• Grammar and Translation suite selling price
  290 per copy
• Allocated to Grammar 255
• Remaining to be allocated (290 255) 35 gt
  Translation