Service Department Cost Allocations

1
Service DepartmentCost Allocations

• Appendix 3-1

2
Operating Expense Allocations

• Traditional cost accounting systems assign
  operating expenses to products with a two-stage
  procedure
• Expenses are assigned to production departments
• Production department expenses are assigned to
  the products
• Departmental structure influences the
  first-stage allocation process

3
Effect Of Departmental Structure

• Departments that have direct responsibility for
  converting raw materials into finished products
  are called production departments
• Service departments perform activities that
  support production, such as

• Production engineering

• Machine maintenance

• Machine setup

• Production scheduling

• All service department costs are indirect support
  activity costs because they do not arise from
  direct production activities

4
Two-Stage Cost Allocation

• Conventional product costing systems assign
  indirect costs to jobs or products in two stages
• In the first stage
• System identifies indirect costs with various
  production and service departments
• Service department costs are then allocated to
  production departments
• The system assigns the accumulated indirect costs
  for the production departments to individual jobs
  or products based on predetermined departmental
  cost driver rates

5
Two-Stage Cost Allocation (2 of 2)
6
Allocating Service Department Costs To Production
Departments

• There are three ways that companies allocate
  service department costs to production
  departments
• Direct allocation
• Sequential allocation
• Reciprocal allocation
• The last two are used when service departments
  consume services provided by other departments

7
PATIENTAID EXAMPLE
Step 1 of Stage 1 cost allocations (given)
8
Direct Allocation Method

• The direct allocation method is a simple method
  that allocates the service department costs
  directly to the production departments
• Allocations to production departments are based
  on each production departments relative use of
  the applicable cost driver
• Possibility that some of the activities of a
  service department may benefit other service
  departments as well as production departments is
  ignored

9
Allocation Bases Values
10
Allocation Ratios
Based on relative allocation basis value
300,000 / 1,200,000 0.250
11
Allocation ofService Department Costs

• Multiply service department cost by the
  allocation ratios

160,000 x 0.250 40,000
12
Stage 2 Cost Allocations

• Stage 2 allocations
• Require the identification of appropriate cost
  drivers for each production department
• Assign production department costs to jobs and
  products while they are worked on in the
  departments
• Conventional cost accounting systems use
  unit-related cost drivers
• Dividing the indirect costs accumulated in each
  production department by the total number of
  units of the corresponding cost driver results in
  cost driver rates for each department

13
PATIENTAID Stage 2

• The Casting Department allocates its indirect
  costs to jobs based on machine hours, with total
  capacity for Casting equaling 6,000 machine hours
• Total indirect costs for Casting, after the
  allocation from service departments in Step 2 of
  Stage 1 was 216,000
• As a result, Casting allocates indirect costs to
  jobs at a rate of 36.00 per machine hour
• 216,000/6,000 hours

14
PATIENTAID Stage 2

• If Job J189-4 uses 40 machine hours while in the
  Casting Department, Casting will allocate 1,440
  of its indirect costs to Job J189-4
• 40 hours x 36.00 per hour
• Each department will allocate indirect costs to
  Job J189-4 in a similar manner, and Casting will
  allocate some costs to all jobs in a similar
  manner
• To determine the total cost of Job J198-4, add
  the Direct Material and Direct Labor cost
  assigned in each department and the indirect cost
  allocated from each department
• To determine the cost per unit, divide the total
  cost by the number of units in Job J189-4

15
Cost Distortions inA Two-Stage Allocation

• The two-stage allocation can cause some products
  to be overcosted and others undercosted if
  allocations are based on unit measures but the
  units of different products have different
  relative consumption ratios

16
Cost Distortions inA Two-Stage Allocation (2 of
2)

• Cost distortions are greater when the difference
  between the relative proportion of the cost
  driver for the activity and the relative
  proportion of the basis for second-stage
  assignment of support costs is greater
• Such distortions could be eliminated if the
  costing system used the actual cost driver for
  each support activity to assign costs directly to
  the products

17
Sequential and ReciprocalAllocation Methods

• Sequential and reciprocal allocation methods are
  used when service departments consume services
  provided by other service departments
• The sequential allocation method allocates
  service department costs to one service
  department at a time in sequential order
• The reciprocal allocation method determines
  service department cost allocations simultaneously

18
Sequential Allocation Method

• The sequential 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

19
Sequential Allocation Method

• The sequential allocation method requires that
  the service departments first be arranged in
  order
• 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

20
Sequential Allocation Method
480,000/800,000 0.600 2,000/4,000 0.500
21
Sequential Allocation Method
320,000 0.600 192,000 (180,000 40,000)
0.500 110,000
22
Sequential Allocation Method

• The power department does not receive engineering
  services, but the engineering department uses
  power
• Therefore, in the sequential method
• Power department costs are allocated first
• Engineering department costs are allocated next
• 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

23
Reciprocal Allocation Method

• If both service departments in this example
  consume each others services, the reciprocal
  allocation method is appropriate
• The sequential method ignores or suppresses such
  reciprocal relations
• The reciprocal allocation method recognizes
  reciprocal interactions between different service
  departments

24
Reciprocal Allocation Method
480,000/800,000 0.600 2,000/5,000 0.400
25
Reciprocal Allocation Method

• Before allocating any costs to the production
  departments, determine the reciprocal allocation
  between service departments
• Powers total cost is 320,000 20 of the total
  cost of Engineering (P320,000.20E)
• Engineerings total cost is 180,000 12.5 of
  the total cost of Power (E180,000.125P)
• Solve the simultaneous equations by substitution

26
Reciprocal Allocation Method

• P320,000.20E, with E180,000.125P
• P320,000.20(180,000.125P)
• P320,000 36,000 .025P
• .975P320,000 36,000
• P 365,128
• E180,000.125P
• E180,000.125(365,128)
• E180,00045,641
• E 225,641

These costs will be allocated to the production
departments using the allocation ratios shown
previously
27
Reciprocal Allocation Method
(320,000 45,128) 0.600 192,000 (180,000
45,641) 0.400 110,000
28
Reciprocal Allocation Method

• The power departments total costs were higher
  because it also consumed some engineering
  services
• Because the machining department consumed a
  relatively larger amount of power, the costs
  allocated to it were higher in this case
• Only the allocations were different the total
  amount of costs did not change as a result of
  using a different allocation method

29
Final Word on Two-Stage Allocation

• The two-stage allocation method assumes the
  absence of a strong direct link between the
  support activities and the products manufactured
• Activity-based costing rejects this assumption
  and assumes that cost drivers directly link the
  activities performed to the products manufactured
  and measure the average demand placed on each
  activity by the various products