Week 3

1
Week 3

• Service Department Costs

2
Service Department Costing

• Typically, process costing uses a single cost
  driver to assign costs in a production department
  to products.

• But what do you do about service departments?
• Service departments do not (normally) earn
  revenues.
• So how does management determine how much
  overhead cost from the service departments
  belongs to each operating department?

3
Service Department Costing

• Should service department costs be allocated to
  operating departments?

• Service departments are necessary for the
  production of goods and services (at least
  indirectly), so there should be some provision
  for the costs of the services in the
  determination of unit costs.

4
Service Department Costing

• Should service department costs be allocated to
  operating departments?

• This can be justified by the fact that if these
  services were not supplied internally (by the
  service department), they would likely be paid
  for externally.
• If acquired externally, the cost would be
  included in the costs of production.

5
Internal or Outsourced Support Services?
Factors to be Considered
Reliable Service Providers
Sensitive Information
6
Managing Internal Support-Service Costs
Alternatives
Charge the cost of support services to using
departments and possibly recover the costs from
these internal customers.
Do not charge internal customers for support
services and recover the costs from general
revenue.
7
Service Department Costing

• So what is the process by which service
  department costs can be charged to production
  departments?

• First, we identify the activities that drive
  costs in the service department.
• This cost driver is called the allocation base.

8
Service Department Costing

• So what is the process by which service
  department costs can be charged to production
  departments?

• Second, we measure the consumption of the
  allocation base in the production departments.

• Third, we allocate the service department cost
  based on the relative amount of the allocation
  base used in each production department.

9
Service Department Costing

• What happens to service department costs after
  they are charged to production departments?

• The production department might reimburse the
  service department, but most likely the allocated
  service department costs become a part of
  themanufacturing overhead in the production
  department.

10
Service Department Cost Allocations
Service Department (Cafeteria)
DirectandIndirectCosts
ProductionDepartment (Machining)
Service Department (Accounting)
TheProduct
ProductionDepartment (Assembly)
Service Department (Personnel)
11
Service Department Cost Allocations
First Phase Trace direct costsand allocate
indirect costs to all departments
Service Department (Cafeteria)
DirectandIndirectCosts
ProductionDepartment (Machining)
Service Department (Accounting)
TheProduct
ProductionDepartment (Assembly)
Service Department (Personnel)
12
Service Department Cost Allocations
13
Service Department Cost Allocations
Third Stage Producing department overhead costs
and allocated service department costs are
applied to products.
14
Service Department Cost Allocations
A cost driver is thefactor that causes or
drivesan activitys costs.
15
Service Department Cost Allocations
CausalRelation
BenefitsReceived
A cost driver is thefactor that causes or
drivesan activitys costs.
16
Service Department Cost Allocations
17
Service Department Cost Allocations
18
Service Department Cost Allocations

• There are three approaches for the allocation of
  service department costs

• Direct method
• Step method and
• Reciprocal method.

19
Direct Method

• The direct method is the simplest in that it
  allocates service department costs directly to
  production departments.

• Allocations are based on each production
  departments relative use of the applicable cost
  driver.
• It ignores opportunity costs and the possibility
  that some of the activities of a service
  department may benefit other service departments
  as well as production departments.

20
Direct Method
Service Department (Cafeteria)
ProductionDepartment (Machining)
Cost of servicesbetween service departments
areignored and all costs areallocated
directlyto productiondepartments.
Service Department (Custodial)
ProductionDepartment (Assembly)
21
Direct Method Example
22
Direct Method Example
23
Direct Method Example
Allocation base Number of employees
24
Direct Method Example
Allocation base Number of employees
25
Direct Method Example
Allocation base Square feet occupied
26
Direct Method Example
Allocation base Square feet occupied
27
Service Department Costing

• The step and the reciprocal methods recognize
  that service departments also benefit other
  service departments.

• The step method considers some inter-departmental
  services (but not all).
• This method allocates service department costs to
  one service department at a time in step, or
  sequential order.

28
Service Department Costing

• The step method is appropriate when there is not
  a pair of service departments in which each
  department in that pair consumes a significant
  proportion of the services produced by the other
  department in that pair.

• The step method requires that service departments
  be arranged in order.

29
Service Department Costing

• A service department can receive costs allocated
  from another service department only before its
  own costs have been allocated to other
  departments.

• Once a service departments costs have been
  allocated, no costs can be allocated back to it
  from other departments.

30
Service Department Costing

• The step method reduces the subsidization of
  service department use of other service
  departments.

• However, the step method still misstates
  opportunity costs, and some service departments
  are not charged for the use of other service
  departments.
• Further, the selection of which department is
  allocated first results in different cost
  allocations.

31
Step Method
Service Department (Cafeteria)
ProductionDepartment (Machining)
Service departmentcosts are allocatedto other
service departments andto productiondepartments,
usuallystarting with theservice
departmentthat provides thegreatest amount of
service to other departments.
Service Department (Custodial)
ProductionDepartment (Assembly)
32
Step Method
Service Department (Cafeteria)
ProductionDepartment (Machining)
Once a servicedepartments costsare allocated,
other servicedepartment costsare not
allocatedback to it.
Service Department (Custodial)
ProductionDepartment (Assembly)
33
Step Method
Service Department (Cafeteria)
ProductionDepartment (Machining)
Custodial willhave a newtotal to allocateto
productiondepartments itsown costs plusthose
costsallocated fromthe cafeteria.
Service Department (Custodial)
ProductionDepartment (Assembly)
34
Step Method Example
35
Step Method Example
Allocation base Number of employees
36
Step Method Example
20 10 20 30
360,000
120,000
Allocation base Number of employees
37
Step Method Example
30 10 20 30
360,000
180,000
Allocation base Number of employees
38
Step Method Example
New total 90,000 original custodial cost plus
60,000 allocated from the cafeteria.
39
Step Method Example
25,000 25,000 50,000
50,000
150,000
Allocation base Square feet occupied
40
Step Method Example
50,000 25,000 50,000
100,000
150,000
Allocation base Square feet occupied
41
Step Method Example

• The total cost of a service department allocated
  to other departments equals the amount directly
  identified with the service department plus the
  amount allocated earlier to the service
  department from other service departments.

42
Reciprocal Method

• The step and the reciprocal methods recognize
  that service departments also benefit other
  service departments.

• The reciprocal method is the most accurate but
  also the most complex as it considers all
  services provided between service departments.
• It determines service department cost allocations
  simultaneously.

43
Reciprocal Method

• If both service departments in the earlier
  example consume each others services, the
  reciprocal allocation method is appropriate.

• It is the theoretically correct method of
  allocating costs, and it provides the closest
  measurement of opportunity cost.

44
Reciprocal Method

• However, it is a much more complex approach.

• Moreover, it assumes that all costs are variable,
  and that fixed costs should be allocated based on
  expected use a major flaw.

45
Reciprocal Method
Service Department (Cafeteria)
ProductionDepartment (Machining)
Interdepartmentalservices are givenfull
recognitionrather than partialrecognition as
withthe step method.
Service Department (Custodial)
ProductionDepartment (Assembly)
46
Reciprocal Method Example
The Custodial Department receives
10 10 20 30
16
of Cafeteria costs.
The Cafeteria Department receives
5,000 5,000 25,000 50,000
116
of Custodial costs.
The total cost of each service department is
equal to Direct costs of that department
Costs allocated to that department
47
Reciprocal Method Example
The Custodial Department receives
In equation form
16
10 10 20 30
16
Cu 90,000 Ca and Ca
360,000 Cu
of Cafeteria costs.
116
The Cafeteria Department receives
5,000 5,000 25,000 50,000
116
of Custodial costs.
Cu Total costs of Custodial Department Ca
Total costs of Cafeteria Department
48
Reciprocal Method Example
The Custodial Department receives
In equation form
16
10 10 20 30
16
Cu 90,000 Ca and Ca
360,000 Cu
of Cafeteria costs.
116
The Cafeteria Department receives
5,000 5,000 25,000 50,000
116
Two equations and two unknowns are solved by
substitution Ca 360,000 (90,000
Ca) Ca 369,474 (rounded) and Cu
90,000 (369,474) 151,579
of Custodial costs.
116
16
16
49
Step Method Example
50
Step Method Example
10 10 20 30
369,474
61,579
Allocation base Number of employees
51
Step Method Example
20 10 20 30
369,474
123,158
Allocation base Number of employees
52
Reciprocal Method Example
30 10 20 30
369,474
184,737
Allocation base Number of employees
53
Reciprocal Method Example
Allocation base Square feet occupied
54
Reciprocal Method Example
Allocation base Square feet occupied
55
Reciprocal Method Example
Allocation base Square feet occupied
56
Comparison of Methods
57
Reciprocal Method Example

• Notice that the allocations but not the totals
  were different from those obtained using the
  step method.

• The reciprocal method is not commonly used as it
  requires the use of matrix algebra with three or
  more service departments.

58
Comparison of Methods
Cost Allocation Accuracy
The Direct Method does not consider interactions
among service departments.
The Step Method considers some
interactions among service departments.
ABC cost-driver bases should reflect
cause-and-effect relationship between resource
spending and use.
The Reciprocal Method is more thorough in
considering interactions among service
departments, but much more complex.
59
Service Department Costing

• Should we care about variable and fixed costs?

• Recall that the accuracy of any allocation
  depends on the validity of the chosen cost
  drivers.
• Service dept costs should be separated into fixed
  and variable classifications and allocated
  separately.

60
Service Department Costing

• Variable costs should be allocated using one of
  the three methods discussed earlier.

• Fixed costs should be allocated in lump sums
  based on each operating departments anticipated
  peak period usage or long-run average usage from
  the service department.

61
Service Department Costing

• Only budgeted costs for the service departments
  should be allocated to the operating departments.

• This prevents the inefficiencies of a service
  department from being passed on to the operating
  departments.
• Passing the costs down would make the operating
  department appear inefficient.

62
Service Department Costing redux

• The fundamental assumption of the staged
  allocation method is the absence of a strong
  direct link between the support activities and
  the products manufactured.

• For this reason, service department costs are
  first allocated to production departments using
  one of the conventional allocation methods
  previously described.

63
Service Department Costing redux

• Activity-based costing rejects this assumption
  and instead develops the idea of cost drivers
  that directly link the activities performed to
  the products manufactured and measure the average
  demand placed on each activity by the various
  products.

64
Service Department Costing redux

• Activity costs are assigned to products in
  proportion to the average demand that the
  products place on the activities, usually
  eliminating the need for the second step in Stage
  1 allocations.

65
Advantages of Service Department Costing

• The calculation of unit costs by the operating
  departments is a more accurate or true cost,
  as it includes the costs of all services
  necessary in production.

• It makes managers of operating departments more
  aware of the cost of services provided to them gt
  they may use these services more efficiently.

66
Advantages of Service Department Costing

• Unit cost is more comparable to an external cost
  (i.e., for a make or buy decision).

• If operating departments are being charged for
  the services, they will demand better service or
  prices.
• For instance, less expensive than if the service
  is acquired externally, and/or better quality
  service.

67
Disadvantages of Service Department Costing

• Operating departments may be discouraged from
  using services if they are charged for them gt
  which can lead to less efficient production
  and/or lower quality products.

• This is still an allocation process and its
  accuracy in determining unit production costs may
  be questionable.

68
Disadvantages of Service Department Costing

• Perhaps most importantly, especially for bonus
  purposes, allocated service department costs are
  not controllable from the point of view of the
  operating department manager.