Managerial Accounting Balakrishnan | Sivaramakrishnan | Sprinkle | Carty | Ferraro Chapter 16: Support Activity and Dual-Rate Allocations Prepared by Debbie Musil, Kwantlen Polytechnic University

Production & Support Activities A production activity is directly related to producing services or products −Costs are fully traceable to contracts undertaken −Machining, assembly, sales A support activity is not directly related to making or selling a product −Needed to run the business (helps a line activity) −Human resources, payroll Need to allocate costs of both line and staff activities to products LO1: Distinguish between line activities and support activities

What Is The Problem? Most allocations are two-stage systems −Stage 1: Group costs into pools. Pools can be departments, activities, etc. −Stage 2: Identify cost drivers for each pool We have implicitly assumed a simple flow of costs (i.e., assume line activities only) −See following slide In reality, the pattern of resource consumption could be complex (support activities exist) −How should we account for this complexity in cost flows? LO1: Distinguish between line activities and support activities

A Simple Two-Stage Allocation LO1: Distinguish between line activities and support activities

A Complex System LO1: Distinguish between line activities and support activities

Available Options There are three methods that we could use −Direct method −Step-down method −Reciprocal method Methods increase in accuracy from direct to step-down to reciprocal −The number of computations needed also increases −Spreadsheets make step-down method easy to implement −Standard accounting software allows us to implement the reciprocal method LO2: Explain the three methods used to allocate the costs of support activities to products.

Data for Example LO2: Explain the three methods used to allocate the costs of support activities to products.

Direct Method Simplifies allocation problem by ignoring work that service departments do for one another −Note that cost pools for primary activities only go to the cost objects (by definition) Computation: −Recalculate the consumption percentages ignoring any consumption among support departments −Allocate costs as before LO2: Explain the three methods used to allocate the costs of support activities to products.

Direct Method LO2: Explain the three methods used to allocate the costs of support activities to products.

Direct Method: Computations LO2: Explain the three methods used to allocate the costs of support activities to products.

After eliminating consumption by administration, plumbing consumes 42.5% ÷ 85.0% = 50% of the purchasing activity and the Structural Department consumes 25.5% ÷ 85.0% = 30% of the purchasing activity. Direct consumption by contracts accounts for the remainder of 20%. LO2: Explain the three methods used to allocate the costs of support activities to products.

The Step-Down Method Concept −Partially considers reciprocity in consumption −Rank the order of support departments per some criterion (usually size) −Allocate from S1 to all others (including S2, S3…) −S2 cost now includes own cost plus cost allocated from S1 −Allocate from S2 to remaining departments (S3,…) −In this way, we close out one support pool at each step LO2: Explain the three methods used to allocate the costs of support activities to products.

Step-Down Method LO2: Explain the three methods used to allocate the costs of support activities to products.

Step-Down Method: Computations LO2: Explain the three methods used to allocate the costs of support activities to products.

Step-Down Method Also known as the sequential method −Departments are sequentially allocated The ordering of support departments matters −Choice is often strategic as managerial incentives are affected −Affects consumption of allocated resource Attempt to minimize allocation LO2: Explain the three methods used to allocate the costs of support activities to products.

Solution presented in next slide. LO2: Explain the three methods used to allocate the costs of support activities to products.

Solution for Check It Exercise #2 There is no need to revise the pattern for purchasing as we allocate costs to all units that consume this activity. The revised consumption pattern from administration = (28% ÷ 70%) = 40% for plumbing and (14% ÷ 70%) = 20% for contracts. Costs allocated from purchasing are $37,500 (= 0.15 x $250,000) to administration, $106,250 to plumbing, and $42,500 directly to contracts. The total cost in administration is now $37,500 + $650,000 = $687,500. From administration, we therefore allocate 0.40 x $687,500 = $275,000 each to structural and plumbing, and 0.20 x $687,500 = $137,500 directly to contracts. The final totals are $1,373,750 for structural, $1,640,000 for plumbing, and $528,750 for contracts. LO2: Explain the three methods used to allocate the costs of support activities to products.

The Reciprocal Method Conceptually most accurate −Takes into account all work that departments do for each other Views the allocation problem as a system of equations −Uses matrix algebra to solve Easily implemented with modern computer packages −Makes interpretation of rates quite hard, however −The rate from S1 includes cost from S2, S3 etc, each of which has costs from S1! This circularity has potential to confuse the casual user LO2: Explain the three methods used to allocate the costs of support activities to products.

Mechanics Set up system of equations −A = $650, P −P = $250, A. Solve this system of equations by substituting the second equation into the first −A = $719,895, P = $465,969 Can use Excel for more complex systems LO2: Explain the three methods used to allocate the costs of support activities to products.

Reciprocal Method: Computations LO2: Explain the three methods used to allocate the costs of support activities to products.

Predetermined Overhead Rates Support allocations can be integrated with overhead rates Suppose −$719,895 allocated from admin cost pool under reciprocal method −SAC has 300 employees (incl. 8 in administration) Net 292 employees for the allocation −Rate = $719,895 ÷ 292 = $2,465 per head Managers of the other line and support activities would be charged $2,465 as the cost of administration for each employee assigned to them LO2: Explain the three methods used to allocate the costs of support activities to products.

Why Integrate? Helps sensitize managers that support services are not free Provides incentives to control driver quantity and thereby the allocated cost −Try to make do with fewer employees The allocation is often seen as arbitrary −Driver quantity and rate are often not controllable −Lack of transparency in the system Why allocate $719,895 when cost is only $650,000? LO2: Explain the three methods used to allocate the costs of support activities to products.

Solution presented in next slide. LO2: Explain the three methods used to allocate the costs of support activities to products.

 Under the direct method, total cost is $250,000 (Exhibit 16.5) and the denominator volume is 850 orders (1, for self- consumption for administration). Thus, the rate per order is $ (rounded).  For the step-down method, the cost in the pool is $445,000 (Exhibit 16.7). Because we only allocate these costs to structural, plumbing and contracts, the denominator volume is = 850 orders. Thus, the rate is $ per order (rounded).  The denominator volume for the reciprocal method is 1,000 orders (we include the 150 orders from administration as we allocate costs back to administration). The rate is $465,968 ÷ 1,000 orders = $ per order.  Under the direct method, total cost is $250,000 (Exhibit 16.5) and the denominator volume is 850 orders (1, for self- consumption for administration). Thus, the rate per order is $ (rounded).  For the step-down method, the cost in the pool is $445,000 (Exhibit 16.7). Because we only allocate these costs to structural, plumbing and contracts, the denominator volume is = 850 orders. Thus, the rate is $ per order (rounded).  The denominator volume for the reciprocal method is 1,000 orders (we include the 150 orders from administration as we allocate costs back to administration). The rate is $465,968 ÷ 1,000 orders = $ per order. Solution for Check It Exercise #3 LO2: Explain the three methods used to allocate the costs of support activities to products.

Dual-Rate Allocations Incorporates the cost hierarchy into the allocations The cost pool for a department might contain unit, batch, product and facility level costs −Separate them into distinct pools and choose suitable drivers In practice, −Only two pools are made: Fixed and variable costs −Variable costs allocated based on actual use patterns −Fixed (capacity) costs allocated based on long-term use patterns LO3: Discuss the need for dual-rate allocations

Example Total cost of printing = $125 × number of prints −But, if allocated at this rate, we might under- utilize printing −User-manager sees controllable cost as $125! −But, only $50 per print might be controllable in the short-term A better allocation −$112,500 + $50 per actual print ordered −$112,500 is a lump-sum allocation based on long-term demand −$50 per print is a variable cost incurred because of transaction LO3: Discuss the need for dual-rate allocations

Why Separate? Send clear signals re: the costs that are controllable over differing time horizons −Decisions regarding service use (which user- department managers control) based on more relevant data −Affects the amount of capacity to install LO3: Discuss the need for dual-rate allocations

Direct method (LO2). The City of Pleasantville has two departments - Parks and Recreation (P&R) and Facility Maintenance (FM) - that provide services to its citizens. The P&R Department offers many programs in art, culture, and athletics, while the FM Department maintains all of the streets, buildings, and other public facilities. Behind the scenes, Pleasantville has two departments that support the activities of the P&R and FM departments. The Human Resources Department processes payroll and oversees all hiring, development, and training. The General Administration Department provides overall coordination and managerial support. The following table provides data regarding the consumption of services by the various activity pools/departments, as well as the amount of costs traced to each activity pool. Exercise 16.21

Required: Allocate the costs of the two support departments to the line departments, using the direct method. Compute the total costs in the cost pool for the P&R and FM departments. Exercise (Continued)

The key idea in the direct allocation method is that we do not allocate costs from one support department to another support department. Thus, we could think of the direct method in two steps. First, compute the allocation percentages, ignoring the services provided to other support departments. Second, perform the allocations.

Exercise (Continued) In this exercise, we have two support departments: Human Resources and General Administration. Thus, for step 1, we have: Human Resources General Administration Parks and Recreation Facilities Maintenance Services Provided by Human Resources 1 50% General Administration 2 75%25% 1 50% = (30/60) where 60 is the total of the support provided to non-service- pools/departments. 2 75% = (60/80) where 80 is the total of the support provided to non-service- pools/departments; likewise for the FM department.

Exercise (Concluded) We can now perform the second step: allocate costs. We know that HR has $100,000 and GA has $60,000 in costs. Thus, we have: Human Resources General Admin. Parks and Recreation Facilities Maintenance Traced costs$100,000$60,000$360,000$450,000 Costs allocated from Human Resources 1 (100,000)50,000 General Administration 2 (60,000)45,00015,000 Total00$455,000$515, ,000 = 0.50 × $100, $45,000 = 0.75 × $60,000. After the allocation, we have $455,000 in P&R and $515,000 in the FM department. The total amount in these two pools is $970,000, the total overhead that we began with for the four cost pools.

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