Allocation of Support Department Costs, Common Costs, and Revenues Chapter 15

Differentiate the single-rate cost-allocation method. Learning Objective 1 Differentiate the single-rate from the dual-rate cost-allocation method.

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.

Understand how the uncertainty user managers face is affected Learning Objective 2 Understand how the uncertainty user managers face is affected by the choice between budgeted and actual cost-allocation rates.

Budgeted versus Actual Rates 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. Why?

Budgeted versus Actual Rates – because the user departments do not pay for any costs that exceed the budgeted rates When actual rates are used for cost allocation, managers do not know the rates to be used until the end of the budget period.

Budgeted versus Actual Usage Allocation Bases Organizations commit to infrastructure costs on the basis of a long-run planning horizon. The use of budgeted usage to allocate these fixed costs is consistent with the long-run horizon.

Allocate support department costs using the direct, step-down, Learning Objective 3 Allocate support department costs using the direct, step-down, and reciprocal methods.

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.

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. Reciprocal allocation method: Allocates costs by services provided among all support departments.

Allocating Support Departments Costs The Canton Division of Smith Corporation has two operating departments and two support departments. Assembly and Finishing Maintenance and Human Resources

Allocating Support Departments Costs Total square feet = 255,000 Total number of employees = 95 Maintenance is allocated using square feet. Human Resources is allocated using number of employees.

Allocating Support Departments Costs Human Maintenance Resources Budgeted costs before allocations: $300,000 $2,160,000 Square feet: 5,000 30,000 Number of employees: 8 15

Allocating Support Departments Costs Assembly Finishing Budgeted costs before allocations: $1,700,000 $900,000 Square feet: 110,000 110,000 Number of employees: 48 24

Operating Departments Direct Method Support Departments Operating Departments Maintenance $300,000 $1,700,000 Assembly 110/220 0% 0% 48/72 110/220 Human Resources $2,160,000 $900,000 Finishing 24/72

Operating Departments Direct Method Support Departments Operating Departments Maintenance $300,000 $1,700,000 Assembly $150,000 0% 0% $1,440,000 $150,000 Human Resources $2,160,000 $900,000 Finishing $720,000

Direct Method 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

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: 30,000 ÷ 250,000 (or 12%) × $300,000 = $36,000

Step-Down Method Maintenance to Assembly: 110,000 ÷ 250,000 (or 44%) × $300,000 = $132,000 Maintenance to Finishing: 110,000 ÷ 250,000 (or 44%) × $300,000 = $132,000

Step-Down Method Costs before Allocated allocation costs Maintenance: $ 300,000 ($300,000) Human Resources: $2,160,000 $ 36,000 Assembly: $1,700,000 $132,000 Finishing: $ 900,000 $132,000

Step-Down Method 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

Step-Down Method Costs before Allocated Allocated allocation costs costs Human Resources: $2,160,000 $ 36,000 ($2,196,000) Assembly: $1,700,000 $132,000 $ 1,464,000 Finishing: $ 900,000 $132,000 $ 732,000

Step-Down Method Total cost after allocation: Assembly Department: $1,700,000 + $132,000 + $1,464,000 = $3,296,000 Finishing Department: $900,000 + $132,000 + $732,000 = $1,764,000

Human Resource cost = $2,160,000 + .12M Reciprocal M HR A F Maintenance – 12% 44% 44% Human Resources 10% – 60% 30% Maintenance cost = $300,000 + .10P Human Resource cost = $2,160,000 + .12M

Reciprocal Maintenance cost (M) = $300,000 + .10($2,160,000 + .12M) HR = $2,160,000 + .12($522,267) HR = $2,160,000 + $62,672 = $2,222,672

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 Total cost Assembly Department: $3,263,400 Total cost Finishing Department: $1,796,599

Overview of Methods Overhead rate for the Assembly Department is determined using direct labor cost as a denominator. Overhead rate for the Finishing Department is determined using machine-hours as the denominator.

What are the various overhead rates using the three methods? Comparison of Methods Assembly Finishing Direct labor cost: $698,880 $349,440 Machine-hours: 24,000 23,500 What are the various overhead rates using the three methods?

Overhead Rates Direct Method Assembly: $3,290,000 ÷ $698,880 direct labor costs = 471% of direct labor costs Finishing: $1,770,000 ÷ 23,500 = $75.32 per machine-hour

Overhead Rates Step-Down Method Assembly: $3,296,000 ÷ $698,880 direct labor costs = 472% of direct labor cost Finishing: $1,764,000 ÷ 23,500 = $75.06 per machine-hour

Overhead Rates Reciprocal Assembly: $3,263,400 ÷ $698,880 direct labor costs = 467% of direct labor cost Finishing: $1,796,599 ÷ 23,500 = $76.45 per machine-hour

Comparison of Rates Assembly Finishing Direct method: 471% $75.32 Step-down method: 472% $75.06 Reciprocal method: 467% $76.45

using either the stand-alone Learning Objective 4 Allocate common costs using either the stand-alone or incremental method.

Allocating Common Costs Two methods for allocating common cost are: 1. Stand-alone cost allocation method 2. Incremental cost allocation method

Stand-Alone 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.

Stand-Alone Example 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 Example How much should the consultant charge to the North Carolina client? $360 ÷ ($360 + $540) = .40 .40 × $760 = $304 How much to the international client? $760 – $304 = $456

Incremental Cost Example Assume that the business meeting in Chicago is viewed as the primary party. What would be the cost allocation? International client (primary) $540 Durham client (incremental) $760 – $540 = $220

Explain the importance of explicit agreement between Learning Objective 5 Explain the importance of explicit agreement between contracting parties when reimbursement is based on costs incurred.

Cost Allocation and Contracts Many commercial contracts include clauses that require the use of cost accounting information. Contract disputes arise with some regularity, often with respect to cost allocation. Cost assignment rules should be as explicit as possible (and in writing).

Understand how bundling of products gives rise to Learning Objective 6 Understand how bundling of products gives rise to revenue-allocation issues.

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.

Revenues and Bundled Products What businesses provide bundled products? Banks Hotels Tours Checking Safety deposit boxes Investment advisory Lodging Food and beverage services Recreation Transportation Lodging Guides

Allocate the revenues of the individual products Learning Objective 7 Allocate the revenues of a bundled package to the individual products in that package.

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.

Revenue Allocation Methods Stand-alone Price Grammar $255 Translation $ 85 Composition $185 Purchasing these software programs costs English the following: Grammar $180 Translation $ 45 Composition $ 95

Revenue Allocation Methods Bundle (Suites) Price Grammar + Translation $290 Grammar + Composition $350 Grammar + Translation + Composition $410

Revenue Allocation Methods The two main revenue allocation methods are: 1. The stand-alone method 2. The incremental method

Stand-Alone Revenue Allocation Method There are four types of weights for the stand-alone revenue allocation method. 1. Selling prices 2. Unit costs 3. Physical units 4. Stand-alone product revenues

Stand-Alone Revenue Allocation Method Consider the Grammar and Translation suite, which sells for $290 per day. How much weight should English Languages Institute assign to each item?

Stand-Alone Revenue Allocation Method Selling prices: The individual selling prices are $255 for Grammar and $85 for Translation. Grammar: $255 ÷ $340 = 0.75, $290 × 0.75 = $217.50 Translation: $85 ÷ $340 = 0.25, $290 × 0.25 = $72.50

Stand-Alone Revenue Allocation Method Unit costs: This method uses the costs of the individual products to determine the weights for the revenue allocations. Grammar: $180 ÷ $225 = 0.80, $290 × 0.80 = $232 Translation: $45 ÷ $225 = 0.20, $290 × 0.20 = $58

Stand-Alone Revenue Allocation Method Physical units: This method gives each product unit in the suite the same weight when allocating suite revenue to individual products. With two products in the suite, each product is allocated 50% of suite revenues. 1 ÷ (1 + 1) = 0.50 $290 × 0.50 = $145

Stand-Alone Revenue Allocation Method Stand-alone product revenues: This method captures the quantity of each product sold as well as their selling prices. Assume that the stand-alone revenues in 2003 are Grammar $734,400, Translation $81,600, and Composition $133,200. What are the weights for the Grammar and Translation suite?

Stand-Alone Revenue Allocation Method Grammar: $734,400 ÷ $816,000 = 0.90, $290 × 0.90 = $261 Translation: $81,600 ÷ $816,000 = 0.10, $290 × 0.10 = $29

Stand-Alone Revenue Allocation Method Revenue Allocation Weights Grammar Translation Selling prices $217.50 $ 72.50 Unit costs 232.00 58.00 Physical units 145.00 145.00 Stand-alone product revenues 261.00 29.00

Incremental Revenue Allocation Method The first-ranked product is termed the primary product in the bundle. The second-ranked product is termed the first incremental product. The third-ranked product is the second incremental product, and so on.

Incremental Revenue Allocation Method Assume that Grammar is designated as the primary product. 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.

Incremental Revenue Allocation Method Grammar and Translation suite selling price = $290 per day Allocated to Grammar: $255 Remaining to be allocated: ($290 – $255) = $35 Allocated to Translation: $35

End of Chapter 15