Service Department Costing: An Activity Approach Chapter 15 Service Department Costing: An Activity Approach

The Need for Cost Allocations Operating Departments Carry out the central purposes of an organization Service Departments Provide support to the operating departments

The Need for Cost Allocations First, we identify the factor that drives costs in the service department. This cost driver is used as the allocation base. How are service department costs charged to operating departments?

The Need for Cost Allocations Second, we measure the consumption of the allocation base in the operating departments.

The Need for Cost Allocations Third, we allocate the service department cost based on the relative amount of the allocation base used in each operating department.

The Need for Cost Allocations Allocated service department costs become a part of the overhead in each operating department. What happens to service department costs after they are allocated to operating departments?

The Need for Cost Allocations I get it. They become a part of the overhead that is applied to products with a predetermined overhead rate. That’s right. Take a look at this flow chart. I think it will summarize our discussion of the allocation process.

The Need for Cost Allocations First Stage Allocations Service department costs are allocated to operating departments. Service Department (Cafeteria) Operating Department (Machining) Service Department (Accounting) The Products Operating Department (Assembly) Service Department (Personnel)

The Need for Cost Allocations Second Stage Allocations Operating department overhead costs and allocated service department costs are applied to products. Service Department (Cafeteria) Operating Department (Machining) Service Department (Accounting) The Products Operating Department (Assembly) Service Department (Personnel)

Guidelines for Cost Allocation Allocation bases Interdepartmental services Allocating costs by behavior Allocation pitfalls to avoid Allocation of actual or budgeted costs $ Service Departments Operating Departments

Selecting Allocation Bases Personnel: Number of employees Criteria Custodial: Square footage Easiest Receiving: Units handled Cafeteria: Number of employees Security: Square footage Accounting: Staff hours Power: Kilowatt hours

Selecting Allocation Bases Personnel: Number of employees Criteria Custodial: Square footage Availability of space or equipment Receiving: Units handled Cafeteria: Number of employees Security: Square footage Accounting: Staff hours Power: Kilowatt hours

Selecting Allocation Bases Personnel: Number of employees Criteria Custodial: Square footage Receiving: Units handled Benefits received by the operating department Cafeteria: Number of employees Security: Square footage Accounting: Staff hours Power: Kilowatt hours

Selecting Allocation Bases Personnel: Number of employees Criteria Custodial: Square footage Receiving: Units handled Consumption of resources Cafeteria: Number of employees Security: Square footage Accounting: Staff hours Power: Kilowatt hours

Interdepartmental Services Problem Allocating costs when service departments provide services to each other Solutions Direct Method Step method Reciprocal method

Direct Method Service Department (Cafeteria) Operating Department (Machining) Interactions between service departments are ignored and all costs are allocated directly to operating departments. Service Department (Custodial) Operating Department (Assembly)

Direct Method Example

Direct Method Example

Direct Method Example $360,000 × 20 20 + 30 = $144,000 $360,000 × 20 20 + 30 = $144,000 Allocation base: Number of employees

Direct Method Example $360,000 × 30 20 + 30 = $216,000 $360,000 × 30 20 + 30 = $216,000 Allocation base: Number of employees

Direct Method Example $90,000 × 25,000 25,000 + 50,000 = $30,000 $90,000 × 25,000 25,000 + 50,000 = $30,000 Allocation base: Square feet occupied

Direct Method Example 50,000 25,000 + 50,000 $90,000 × = $60,000 $90,000 × = $60,000 Allocation base: Square feet occupied

Step Method Service Department (Cafeteria) Operating Department (Machining) Once a service department’s costs are allocated, other service department costs are not allocated back to it. Service Department (Custodial) Operating Department (Assembly)

Step Method Service Department (Cafeteria) Operating Department (Machining) Custodial will have a new total to allocate to operating departments; its own costs plus those costs allocated from the cafeteria. Service Department (Custodial) Operating Department (Assembly)

Step Method Example We will use the same data used in the direct method example.

Step Method Example Allocate Cafeteria costs first since it provides more service than Custodial.

Step Method Example $360,000 × 10 10 + 20 + 30 = $60,000 $360,000 × 10 10 + 20 + 30 = $60,000 Allocation base: Number of employees

Step Method Example $360,000 × 20 10 + 20 + 30 = $120,000 $360,000 × 20 10 + 20 + 30 = $120,000 Allocation base: Number of employees

Step Method Example $360,000 × 30 10 + 20 + 30 = $180,000 $360,000 × 30 10 + 20 + 30 = $180,000 Allocation base: Number of employees

Step Method Example New total = $90,000 original custodial cost plus $60,000 allocated from the cafeteria.

Step Method Example $150,000 × 25,000 25,000 + 50,000 = $50,000 $150,000 × 25,000 25,000 + 50,000 = $50,000 Allocation base: Square feet occupied

Step Method Example $150,000 × 50,000 25,000 + 50,000 = $100,000 $150,000 × 50,000 25,000 + 50,000 = $100,000 Allocation base: Square feet occupied

Reciprocal Method Service Department (Cafeteria) Operating Department (Machining) Interdepartmental services are given full recognition rather than partial recognition as with the step method. Service Department (Custodial) Operating Department (Assembly) Because of its mathematical complexity, the reciprocal method is rarely used.

Comparison of Methods

Quick Check Data The direct method of allocation is used. Allocation bases: Business school administration costs (ADMIN): Number of employees Business administration computer services (BACS): Number of personal computers

Quick Check  How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000

Quick Check  How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000 $180,000 × 20 20 + 80 = $36,000

Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department? a. $ 52,500 b. $135,000 c. $270,000 d. $ 49,500

Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department? a. $ 52,500 b. $135,000 c. $270,000 d. $ 49,500 $90,000 × 18 18 + 102 = $13,500

Quick Check Data The step method of allocation is used. Allocation bases: Business school administration costs (ADMIN): Number of employees Business administration computer services (BACS): Number of personal computers

Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department? a. $35,250 b. $49,072 c. $18,000 d. $26,333

Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department? a. $35,250 b. $49,072 c. $18,000 d. $26,333

What if we charged a flat annual fee for the service? Allocating Fixed Costs My performance looked good until they allocated those service department costs, so I’m not going to use the service again. But that would not be beneficial to the company; most of those costs are fixed. What if we charged a flat annual fee for the service?

Allocating Fixed Costs That sounds better. If the fee is fixed, the more I use the service the lower my average cost per use will be.

Allocating Costs by Behavior Variable Costs Charge to operating departments at a budgeted rate times the usage of the allocation base. Fixed Costs Allocate budgeted amounts to operating departments in proportion to the peak-period capacity required by the operating department.

Allocating Costs by Behavior Variable Costs Fixed Costs Charge to operating departments at a budgeted rate times the usage of the allocation base. Allocate budgeted amounts to operating departments in proportion to the peak-period capacity required by the operating department. Budgeted costs should be allocated to avoid passing on inefficiencies from the service departments.

Allocating Costs by Behavior Allocations are made at the beginning of the period to provide data for predetermined overhead rates and flexible budgets. Allocations are made at the end of the period to provide data for comparing actual performance to planned performance.

Allocating Costs by Behavior Example SimCo has a maintenance department and two operating departments: cutting and assembly. Variable maintenance costs are budgeted at $0.60 per machine hour. Fixed maintenance costs are budgeted at $200,000 per year. Data relating to the current year are: Allocate maintenance costs to the two operating departments.

Allocating Costs by Behavior Example: Beginning of the Period Hours planned

Percent of peak-period capacity. Allocating Costs by Behavior Example: Beginning of the Period Percent of peak-period capacity.

Allocating Costs by Behavior Example: End of the Period Hours used

Percent of peak-period capacity. Allocating Costs by Behavior Example: End of the Period Percent of peak-period capacity.

Allocating Costs by Behavior Example Fixed cost allocations are the same at the end and at the beginning because they are based on capacity instead of usage.

Quick Check Data Foster City has an ambulance service that is used by the two public hospitals in the city. Variable ambulance costs are budgeted at $4.20 per mile. Fixed ambulance costs are budgeted at $120,000 per year. Data relating to the current year are:

Quick Check  How much ambulance service cost will be allocated to Mercy Hospital at the beginning of the year? a. $117,000 b. $254,400 c. $114,480 d. $119,250

Quick Check  How much ambulance service cost will be allocated to Mercy Hospital at the beginning of the year? a. $117,000 b. $254,400 c. $114,480 d. $119,250

Quick Check  How much ambulance service cost will be allocated to Mercy Hospital at the end of the year? a. $114,000 b. $118,800 c. $110,400 d. $121,200

Quick Check  How much ambulance service cost will be allocated to Mercy Hospital at the end of the year? a. $114,000 b. $118,800 c. $110,400 d. $121,200

Allocation Pitfalls to Avoid Using sales dollars as an allocation base Result Departments that increase revenues are penalized by receiving more allocated costs.

Allocation Pitfalls to Avoid Allocating fixed costs using a variable activity allocation base Result Total fixed costs do not change, but departments that increase activities to support increased revenues are penalized by receiving more allocated costs.

End of Chapter 15