Accounting 3300

1
Allocation of Support Costs, Common Costs
Revenues

• Accounting 3300
• Professor McDermott

2
Definitions

• Operating department or production department
  directly adds value to a product or service.
• Other authors sometimes use the term revenue
  producing department.
• Support or service department provides services
  to operating departments.

3
Questions managers face when allocating support
department costs

• Should fixed costs be allocated to operating
  divisions?
• If fixed costs are allocated, should fixed and
  variable costs be allocated in the same way?

4
Remember

• The allocation of fixed cost is arbitrary.
• There is no cost driver.
• One good reason to allocate fixed costs is for
  cost based pricing.
• It is not good to allocate fixed costs for such
  things as the decision to make or buy a product,
  the decision to close down or continue a
  division, or to evaluation of division
  profitability.
• FASB does, however, require the allocation of
  fixed overhead to cost of goods sold for
  inventory valuation and income determination.

5
Two basic methods to allocate support department
costs

• Single rate method
• Uses one cost driver for both fixed and variable
  costs
• Dual rate method
• Uses two pools, one for variable costs and one
  for fixed costs.

6
Remember there are two parts to support overhead
allocation

• Rate calculation
• Formula overhead costs/base rate
• 10,000 overhead/100,000 units 0.10 per unit
• Overhead allocation
• Base units x overhead rate allocation
• 100,000 units x 0.10 - 10,000 allocation

7
Overhead allocation
Budgeted or actual overhead
Budgeted or actual base
Overhead allocation base units x overhead rate
Budgeted or actual Units
Budgeted rate or actual rate
Why so many options? It depends on what your are
using the information for budgeting, pricing,
motivation of support departments to control
costs, motivation of operating departments to
control support department usage, etc.
8
Most Commonly . . .

• Single rate method calculates rates by dividing
  budgeted costs by budgeted units of base (like
  labor hours).
• Single rate method allocates support department
  costs by multiplying budgeted rate by actual
  units of usage.

9
There is an exception

• The single rate method can calculate the rate by
  dividing budgeted costs by practical capacity
  units.
• The single rate method will then allocate
  overhead by multiplying the practical capacity
  rate by actual units of base used.
• In this case not all of the fixed costs will be
  allocated to operating divisions.
• Some of the fixed costs will be retained by the
  support department.

10
Most Commonly

• Dual rate method calculates variable rate by
  dividing budgeted variable cost by budgeted units
  of base
• Dual rate method calculates fixed rate by
  dividing budgeted fixed rate by budgeted units of
  base

11
Most Commonly

• Dual rate method allocates variable costs by
  multiplying the budgeted rate by actual units of
  base
• Dual rate method allocates fixed cost by
  multiplying the budgeted rate by budgeted units
  of base.

12
There is an exception

• The dual rate method can calculate the fixed
  overhead rate by dividing budgeted fixed costs by
  practical capacity base units.
• The dual rate method then allocates fixed
  overhead by multiplying the budgeted (or
  practical capacity) rate by budgeted units of
  base.
• In this case not all of the actual fixed costs
  will be allocated to operating divisions.
• Some of the fixed costs will be retained by the
  support department.

13
Example

• Lets use real data to illustrate the principles
  given in the last six slides.
• Data comes from authors example pages 532-535.

14
Data Given
15
Most Commonly

• Single rate method calculates rates by dividing
  budgeted costs by budgeted units of base (like
  hours).
• Budgeted cost 3,000,000 fixed costs variable
  cost of (12,000 budgeted hours x 200 per hour)
  5,400,000 budgeted cost
• Rate 5,400,000/12,000 budgeted hours 450
  per hour

16
Most Commonly

• Single rate method allocates support department
  costs by multiplying budgeted rate by actual
  units of usage.
• 450 x 9,000 hours 4,050,000 to Division A
• 450 x 3,000 hours 1,350,000 to Division B

Budgeted hours for Division A were 8,000 for
Division A and 4,000 for Division B.
In this case total budgeted hours were equal to
total used hours, although the hours varied by
department. This is not always the situation.
When it is not, there is over-applied or
under-applied overhead.
17
There is an exception

• The single rate method can calculate the rate by
  dividing budgeted costs by practical capacity
  units.
• One way to calculate this would be to calculate
  the total costs at 18,750 hours.
• 18,750 x 200 3,750,000 variable
• Plus 3,000,000 fixed costs 6,750,000
• 6,750,000/18,750 hours 360 per hour

Budgeted costs
Practical capacity
18
There is an exception

• The single rate method will then allocate
  overhead by multiplying the practical capacity
  rate by actual units of base used.
• 360 x 9,000 actual hours 3,240,000 Div A
• 360 x 3,000 actual hours 1,080,000 Div B
• As mentioned before, the amount allocated
  (3,240,000 1,080,000 4,320,000) does not
  equal budgeted costs of 5,400,000. The
  difference between 4,320,000 and 5,400,000
  (1,080,000) represents fixed costs retained by
  the support department. This coincidentally is
  the same amount as the allocation for Div B.

19
Most Commonly

• Dual rate method calculates variable rate by
  dividing budgeted variable cost by budgeted units
  of base.
• In the authors example he only gives the 200
  per hour variable rate.
• Dual rate method calculates fixed rate by
  dividing budgeted fixed rate by budgeted units of
  base.
• 3,000,000/12,000 hours 250 per hour fixed rate

20
Most Commonly

• Dual rate method allocates variable costs by
  multiplying the budgeted rate by actual units of
  base
• 200 x 9,000 actual hours 1,800,000 Div A
• 200 x 3,000 actual hours 600,000 Div B
• Dual rate method allocates fixed cost by
  multiplying the budgeted rate by budgeted units
  of base.
• 250 x 8,000 budgeted hours 2,000,000 Div A
• 250 x 4,000 budgeted hours 1,000,000 Div B

21
There is an exception

• The dual rate method can calculate the fixed
  overhead rate by dividing budgeted fixed costs by
  practical capacity base units.
• 3,000,000 budgeted fixed costs/18,750 hours
  160 per hour fixed rate

22
There is an exception

• The dual rate method then allocates fixed
  overhead by multiplying the budgeted rate by
  budgeted units of base.
• 160 x 8,000 budgeted hours 1,280,000 Div A
• 160 x 4,000 budgeted hours 640,000 Div B
• In this case not all of the actual fixed costs
  will be allocated to operating divisions. Some
  will be retained by the support department.
• 1,280,000 640,000 1,920,000 is not equal
  to total fixed costs of 3,000,000. The
  difference is retained by the support department.

23
How will I know which numbers to use?

• The problem should tell you.
• You should be aware of the advantages and
  disadvantages of each alternative, however.

24
Problem 15-16

• Single-rate versus dual rate methods, support
  department.
• The Chicago power plant that services all
  manufacturing departments of Midwest Engineering
  has a budget for the coming year.
• The budgeted numbers on shown on the next slide.

25
Problem 15-16
26
Part 1a

• Assume that a single pool is used for the power
  plant cost.
• What budgeted amount will be allocated to each
  department if the rate is based on practical
  capacity and costs are allocated based on
  practical capacity?

27
Part 1a

• First lets calculate the rate

28
Now lets use the rate to apply support costs to
each department
29
Now lets use the rate to apply support costs to
each department
30
Part 1b

• Still assume that a single pool is used for the
  power plant cost.
• What budgeted amount will be allocated to each
  department if the rate is based on expected
  monthly usage and costs are allocated on expected
  monthly usage?

31
Once again lets calculate the rate
32
Now lets use the rate to apply support costs to
each department
33
Now lets use the rate to apply support costs to
each department
34
Part 2

• Now assume the dual rate is used with separate
  cost pools for the variable and fixed costs,
• Variable costs are allocated on the basis of
  expected monthly usage.
• Fixed costs are allocated on the basis of
  practical capacity.
• What budgeted amounts will be allocated to each
  manufacturing department.

35
Note from Prof. McDermott

• With the dual rate method, fixed costs are almost
  always allocated using budgeted capacity.
• This means that the amount of fixed costs
  budgeted, will be the same as the amount
  allocated.

36
Again the first step is to calculate the
allocation rates
37
Now lets use the rates to allocate power plant
costs to departments

• Lets allocate variable costs first.

38
Now lets use the rates to allocate power plant
costs to departments

• Lets allocate variable costs first.

39
Now lets allocate fixed costs
40
Now lets allocate fixed costs
41
Summing variable and fixed costs allocations
42
Final Question

• Why might you prefer the dual rate method?

43
Problem 15-17

• Single rate method, budgeted versus actual costs
  and quantities.
• Sunrise Inc processes fruit and sells juice and
  preserves.
• It has two growers, both the same distance from
  the plant.
• It operates a trucking fleet that charges for
  variable and fixed costs.
• The fleet has a practical capacity of 250 round
  trips

44
This information is given
45
Using the single rate method . . .

• Calculate budgeted rate and allocate trips based
  on round trips budgeted for each division.

This method essentially turns variable costs into
fixed costs for the plant. The plant knows at the
beginning of the year what its actual overhead
allocations will be. There may, however, be an
incentive for management t of the plant to over
use support services as they dont pay extra if
they exceed budgeted usage.
46
Using the single rate method . . .

• Calculate the budgeted rate per round trip and
  allocate costs based on actual round trips used
  by each division.
• The budgeted rate is the same as in the previous
  example.

47
But the base used to allocate the cost is
different

• Instead of being budgeted hours, it is actual
  hours.
• The formula is budgeted rate x actual trips
• For the Juices division the calculation is
  2,300 x 150 actual trips 345,000
• For the Preserves division the calculation
  is2,300 x 75 actual trips 172,500

48
Advantages and disadvantages of this method

• When budgeted rates are used, the Juice and
  Preserves divisions know what they will be
  charged for each trip. If costs are higher, due
  to poor maintenance etc., the trucking division
  bears the risk.
• Each division can still control transportation
  costs by controlling the trips it uses. The
  transportation division does not bear the risk of
  excess trips.

49
Using the single rate method . . .

• Calculate the actual rate and allocate using
  actual number of trips.

50
Allocation

• Juices division
• 2,150 actual cost/trip x 150 actual trips
  322,500
• Preserves division
• 2,150 actual cost/trip x 75 actual trips
  161,250
• Obviously this method would have to be done at
  year end when actual costs and trips are known.
• If one division uses less trips than budgeted,
  then the fixed costs are spread over fewer trips
  and the other division bears more fixed costs.
  Some divisions would feel this was unfair. This
  is why many favor budgeted versus actual rates
  when using a single rate method.

51
Problem 15-18

• Sunrise decides to examine the effects of using
  the dual-rate method.
• Budgeted costs were
• Variable costs per round trip 1,500
• Fixed costs 200,000
• Actual costs for the 225 round trips made in 2007
  were
• Variable costs 303,750
• Fixed costs 180,000
• Total costs 483,750
• All other information is the same as in problem
  17.

52
Using the dual method allocate costs using
budgeted rates and actual costs

• First lets calculate variable and fixed rates
• We are given the variable rate of 1,500
• We calculate the fixed indirect cost rate . . .

53
Now lets do the allocation
Question to Students. Why are not these two
numbers the same? They are in the allocation for
the Juices Division.
Answer We are allocating fixed costs using
budgeted usage. For the Preserves Division,
actual and budgeted usage was not the same.
54
Dual rate method . . .

• This changes how fixed indirect costs are
  treated. Now they are treated as fixed costs and
  remain the same for budget and allocation.
• By using budgeted trips made, the Juices Division
  is unaffected in its fixed overhead allocation by
  changes from its own budgeted usage, or that of
  other divisions.

55
Allocating Multiple Support Departments

• Three methods are explained in the book.
• The direct methodcosts are allocated directly
  from support departments to operating
  departments. No allocation is made from support
  department to support department.
• The step-down methodcosts are allocated from
  some support departments to other support
  departments before being allocated to operating
  departments.
• The reciprocal methodcosts are allocated from
  all support departments to all support
  departments and production departments.

56
Reciprocal Method

• I wont test you with an actual problem using the
  reciprocal method, as with any organization with
  more than two support departments, simultaneous
  equations involving matrix algebra is required
  and there are better methods that achieve almost
  the same objective.

57
Direct Method
Support Dept
Operating Dept
Support Dept
Operating Dept
Support Dept
Operating Dept
58
Step Down Method
Support Dept
Operating Dept
Support Dept
Operating Dept
Support Dept
Operating Dept
First department allocates to 2 support and 3
operating departments
59
Step Down Method
Support Dept
Operating Dept
Support Dept
Operating Dept
Support Dept
Operating Dept
Second department allocates to one service and 3
operating departments
60
Step Down Method
Support Dept
Operating Dept
Support Dept
Operating Dept
Support Dept
Operating Dept
Third department allocates to 3 operating
departments.
61
Step-Down Method

• More accurate than direct but less accurate than
  reciprocal method.
• The order in which you allocate service
  department costs affects the allocation.
• Once a support departments costs have been
  allocated it receives no further allocation.
• As a result, it does not recognize the total
  services that support departments provide to each
  other.

62
Problem 15-19Support department cost
allocations, direct and step-down

• Phoenix Partners provides management consulting
  services to government and corporate units.
• Phoenix has two support departments,
  Administrative Services and Information Services,
  and two operating departments, Government
  Consulting and Corporate Consulting.
• Cost records for the company are found on the
  following page.

63
Data Provided
64
Direct Method
600,000 x 40/75 320,000.
600,000 x 35/75 280,000
65
Direct Method
66
Direct MethodAS First
67
Step-Down MethodAS First
25/100 x 600,000 150,000 40/100 x 600,000
240,000 35/100 x 600,000 210,000
68
Step-Down MethodAS First
Note the allocation of IS includes the amount
allocated from AS
69
Step-Down MethodAS First
30/90 (not 30/100) x 2,550,000 850,000
70
Step-Down MethodAS First
60/90 x 2,550,000 1,700,000
71
Step-Down MethodAS First
Follow the same procedure to work problem with IS
allocated first.
72
Allocating Common Costs

• A common cost is an activity or like cost object
  that is shared by two or more users.
• The goal is to allocate the costs to each user in
  a equitable way on the basis of individual costs
  of the cost object.

73
Methods of Allocation

• Stand-alone cost methoduses a ratio of the cost
  of the product if purchased individually to the
  cost if purchased as a package.
• Incremental methodranks the individual users of
  a cost object in order of users most responsible
  for commons costs and then uses this ranking to
  allocate costs among those users.
• Shapley value methodconsiders each party as
  first the primary party and then the incremental
  party and takes the average.

74
Problem 15-24Allocation of Common Costs

• Joan, a senior in Sacramento, receives an
  invitation to visit a prospective employer in
  Baltimore.
• A few days later she receives an invitation to
  visit a prospective employer in Chicago.
• She decides to combine her visits traveling from
  Sacramento to Baltimore and then to Chicago and
  then home go Baltimore.
• She makes the trips and accepts the Chicago job.
• She is puzzled over how to allocate her costs to
  the prospective employers.

75
Problem 15-24Allocation of Common Costs

• She has collected the following data for regular
  round-trip fares with no stopovers.
• Sacramento to Baltimore 1,400
• Sacramento to Chicago 1,100
• She paid 1,800 for her three-leg flight. In
  addition she paid 30 each way for limousines
  from her home to Sacramento airport and back when
  she returned.
• Allocate costs using both methods.

76
Problem 15-24Stand-Alone Method

• If she took individual trips to the two
  destinations the total cost would have been
  1,400 for Baltimore 1,100 for Chicago
  2,500.
• Allocation to Baltimore employer
• 1,400/2,500 x 1,800 1,008
• Allocation to Chicago employer
• 1,100/2,500 x 1,800 792
• Total allocation 1,008 792 1,800

77
Problem 15-24Incremental Method

• We will rank Baltimore since that is the first
  trip she planned.
• Baltimore employer is allocated 1,400
• Chicago employer is allocated 1,800 - 1,400
  400
• You could rank Chicago first as they are the ones
  that hired Joan.

78
Problem 15-24 Shapley Value

• Baltimore is allocated 1,400 as the primary
  party (cost of the ticket) and 700 as the
  incremental party for (1,800 1,100 Chicago)
  700.
• The average is (1,400 700)/2 1,050 which
  is the allocation for the Baltimore employee.
• The Chicago employer gets the difference, 1,800
  - 1,050 750.

79
Problem 15-24What method would you prefer?

• The author says
• I would recommend Ernst use the Shapley value. It
  is fairer than the incremental method because it
  avoids considering one party as the primary party
  and allocating more of the common costs to that
  party. It also avoids disputes about who is the
  primary party. It allocates costs in a manner
  that is close to the costs allocated under the
  stand-alone method but takes a more comprehensive
  view of the common cost allocation problem by
  considering primary and incremental users, which
  the stand-alone method ignores.

80
Problem 15-24Options for allocating limousine

• Split it 50/50
• Add it to the 1,800 and allocate it using
• Stand alone method
• Incremental method
• Shapley value method

81
Problem 15-28Single Rate vs. Dual Rate Methods

• Budgeted costs were 1 million in 2006. The
  budgeted variable rate is 12.50 per kwh.
• Carolina Company has designed and built a power
  plant to serve its three plants. Data for 2006 is
  as follows

82
Allocate costs Single Rate calculated on
budgeted usage, allocated on actual usage.


The total rate therefore is 5.00 fixed 12.50
variable 17.50 per kwh
The allocation based on actual usage will
therefore be
83
Allocate costs Single rate calculated on
budgeted usage, allocated on actual usage.



The total rate therefore is 6.25 fixed 12.50
variable 18.75 per kwh
The allocation based on actual usage will
therefore be
84
Allocate costs Dual fixed rate based on
practical capacity and fixed costs allocated on
practical capacity. Variable rate based on
budgeted usage and allocated based on actual.



85
Allocate costs Dual fixed rate based on budgeted
usage and fixed costs allocated on budgeted
usage. Variable rate based on budgeted usage and
allocated based on actual.
86
Problem 15-30Cost Allocation, Actual vs.
Budgeted Usage

• Bulldog Inc. has its own electrical power plant.
• Power is provided to Dept A and Dept B.
• Capacity was originally determined by expected
  peak demands of the two production departments.

87
Problem 15-30

• Expected normal usages are
• Dept A 60,000,000 kwh
• Dept B 40,000,000 kwh
• For November, actual kwh used
• Dept A 60,000,000
• Dept B 20,000,000

88
Problem 15-30

• Budgeted monthly costs of producing power, based
  on normal usage of 100,000,000 kwh are
• 30,000,000 fixed costs
• 7,500,000 variable costs
• Actual costs
• 30,000,000 fixed costs
• 7,500,000

89
Problem 15-30
The controller provides the following report
90
Problem 15-30
List at least two problems with the report.
91
Problem 15-30

• The single-rate method used does not distinguish
  between fixed versus variable costs.
• Actual costs and actual quantities are used.
  This results in managers not knowing cost rates
  until year-end.
• Monthly time periods are used to determine cost
  rates. The use of a monthly time period can
  result in highly variable cost rates depending on
  seasonality, days in a month, demand surges, and
  so on.

92
Problem 15-30

• Prepare a revised monthly allocation report using
  a budgeted rate times actual usage for variable
  costs and a budgeted rate assuming budgeted
  (normal) usage for fixed costs.
• Fixed rate 30,000,000/100,000,000 kwh 0.30
  per kwh
• Variable rate 7,500,000/100.000,000 kwh
  0.075 per kwh

93
Problem 15-30

• Variable costs (actual usage x variable rate)
• Dept A 60,000,000 kwh x 0.075 4,500,000
• Dept B 20,000,000 kwh x 0.075 6,000,000
• Fixed costs (practical capacity x fixed rate)
• Dept A 60,000,000 kwh x 0.30 18,000,000
• Dept B 40,000,000 kwh x 0.30 12,000,000

• Students A better (i.e. less confusing) way to
  allocate fixed cost would be to figure what the
  budget for fixed costs was at the beginning of
  the year and then allocate this exact amount.
• The budget for Dept A was 60,000,000/100,000,000
  x 30,000,000 18,000,000 for Dept A, and
  40,000,000/100,000,000 x 30,000,000
  12,000,000 for Dept B.

There will be 1,500,000 of unallocated variable
costs for November 2006.
94
Problem 15-30

• Discuss the behavioral implications of Lambs
  monthly allocation report for November 2006 on
  the production manager of Department B.
• Risk-exposureChanges in the demand for energy by
  Department A affect the costs Lamb will report
  for Department B. Increases in demand by A will
  reduce Bs cost per kWh and vice versa.
• UncertaintyWhen actual costs are used, managers
  cannot plan costs with certainty

95
Revenue Allocation

• Similar allocation problems can arise when
  multiple products are bundled together and sold
  at a lower bundled price than the price of the
  individual products.
• Microsoft, for example, does this with its Office
  products.

96
Revenue Allocation

• Similar to cost allocation, we can use the
• Stand-alone allocation method
• Incremental allocation method
• Or some type of weighted average method

97
Revenue Allocation and Bundled Products

• Example Suppose this is the cost of individual
  Microsoft packages
• Word--100
• Excel--125
• PowerPoint--200
• Total if purchased individually 425
• Say we sell the package at a cost of 300 and
  then give the revenues to the various developing
  departments.
• The department who developed Word would be
  charged 100/425 x 300 70.58.
• The other departments would be allocated revenue
  using the same methodology.

98
Problem 15-34

• Pebble Resorts operates a five star hotel with a
  world-recognized golf course.
• It has a decentralized management structure.
• There are three divisions
• Lodging
• Food
• Recreation

99
Problem 15-34

• Starting next month, they will offer a two-day,
  two-person getaway package deal for 700.
• The deal includes
• Two round nights stay in a room separately priced
  at 649.
• Two rounds of golf separately priced at 300.
• Dinner separately priced at 160.
• The golf course is operating at 100 capacity.

100
Allocate the 700 package using the stand alone
method

• The base is 640 lodging 300 golfing 160
  dinner 1100 total.
• The hotel would get 640/1100 x 700 407.27
• The golf course would get 300/1100 x 700
  190.91
• The restaurant would get 160/1100 x 700 101.82

101
Allocate the 700 package using the incremental
method (golf, hotel, restaurant)
102
Allocate the 700 package using the incremental
method (golf, hotel, restaurant)
103
Allocate the 700 package using the incremental
method (golf, hotel, restaurant)
104
Allocate the 700 package using the incremental
method (golf, hotel, restaurant)
105
What are the pros and cons of both methods?

• The pros of the stand-alone-revenue-allocation
  method include the following
• Each item in the bundle receives a positive
  weight, which means the resulting allocations are
  more likely to be accepted by all parties than a
  method allocating zero revenues to one or more
  products.
• It uses market-based evidence (unit selling
  prices) to decide the revenue allocationsunit
  prices are one indicator of benefits received .
• It is simple to implement.

106
What are the pros and cons of both methods?

• The cons of the stand-alone revenue-allocation
  method include
• It ignores the relative importance of the
  individual components in attracting consumers to
  purchase the bundle.
• It ignores the opportunity cost of the individual
  components in the bundle. The golf course
  operates at 100 capacity. Getaway participants
  must reserve a golf booking one week in advance,
  or else they are not guaranteed playing time. A
  getaway participant who does not use the golf
  option may not displace anyone. Thus, under the
  stand-alone method, the golf course may be paid
  twiceonce from the non-getaway person who does
  play and second from an allocation of the 700
  package amount for the getaway person who does
  not play (either did not want to play or wanted
  to play but made a booking too late, or failed to
  show).

107
What are the pros and cons of both methods?

•  The cons of the stand-alone revenue-allocation
  method include
• The weight can be artificially inflated by
  individual product managers setting high list
  unit prices and then being willing to frequently
  discount these prices. The use of actual unit
  prices or actual revenues per product in the
  stand-alone formula will reduce this problem.
• The weights may change frequently if unit prices
  are constantly changing. This is not so much a
  criticism as a reflection that the marketplace
  may be highly competitive.

108
What are the pros and cons of both methods?

• The pros of the incremental method include
• It has the potential to reflect that some
  products in the bundle are more highly valued
  than others. Not all products in the bundle have
  a similar write-down from unit list prices.
  Ensuring this potential pro becomes an actual
  pro requires that the choice of the primary
  product be guided by reliable evidence on
  consumer preferences. This is not an easy task.
•  Once the sequence is chosen, it is
  straightforward to implement.

109
What are the pros and cons of both methods?

• The cons of the incremental method include
• Obtaining the rankings can be highly contentious
  and place managers in a no-win acrimonious
  debate. The revenue allocations can be highly
  sensitive to the chosen rankings.
•  Some products will have zero revenues assigned
  to them. Consider the Food division. It would
  incur the costs for the two dinners but receive
  no revenue.

110
The End!
111
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