Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 11 th Edition Chapter 15

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Service Department Costing: An Activity Approach Chapter Fifteen

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Reasons for Allocating Service Department Costs To encourage operating departments to wisely use service department resources. To provide operating departments with more complete cost data for making decisions. To help measure the profitability of operating departments. To create incentive for service departments to operate efficiently. To value inventory for external financial reporting purposes. To include all overhead in the cost base when cost-plus pricing is used.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin $ Selecting Allocation Bases Operating Departments Service Departments The allocation bases used should “drive” the cost being allocated. For example, when allocating costs of the employee cafeteria, the number of meals served would be a good choice for the allocation base. The allocation bases used should “drive” the cost being allocated. For example, when allocating costs of the employee cafeteria, the number of meals served would be a good choice for the allocation base.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Selecting Allocation Bases Operating Departments Service Departments $ A service department’s costs may be allocated using more than one base. For example, a portion of the human resource department costs might be allocated based on the number of employees in each operating department and another portion might be allocated based on hours spent in training employees in each operating department. A service department’s costs may be allocated using more than one base. For example, a portion of the human resource department costs might be allocated based on the number of employees in each operating department and another portion might be allocated based on hours spent in training employees in each operating department.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Examples of Allocation Bases Exh. 15-1

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Interdepartmental Services Problem Allocating costs when service departments provide services to each other Problem Allocating costs when service departments provide services to each other Solutions Direct Method Step Method Reciprocal Method

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method Service Department (Cafeteria) Service Department (Custodial) Operating Department (Machining) Operating Department (Assembly) Interactions between service departments are ignored and all costs are allocated directly to operating departments.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method Example

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method Example

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method Example Allocation base: Number of employees $360,000 × = $144,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method Example Allocation base: Number of employees $360,000 × = $216,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method Example Allocation base: Square feet occupied $90,000 × 25,000 25, ,000 = $30,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method Example Allocation base: Square feet occupied 50,000 25, ,000 $90,000 × = $60,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Operating Department (Machining) Operating Department (Assembly) Step Method Once a service department’s costs are allocated, other service department costs are not allocated back to it. Service Department (Cafeteria) Service Department (Custodial)

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method There are three key points to understand regarding the step method:  In both the direct and step methods, any amount of the allocation base attributable to the service department whose cost is being allocated is always ignored.  Any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored.  Each service department assigns its own costs to operating departments plus the costs that have been allocated to it from other service departments.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example We will use the same data used in the direct method example.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example Allocate Cafeteria costs first since it provides more service than Custodial.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example $360,000 × = $60,000 Allocation base: Number of employees

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example $360,000 × = $120,000 Allocation base: Number of employees

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example $360,000 × = $180,000 Allocation base: Number of employees

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example New total = $90,000 original Custodial cost plus $60,000 allocated from the Cafeteria.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example $150,000 × 25,000 25, ,000 = $50,000 Allocation base: Square feet occupied

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step Method Example $150,000 × 50,000 25, ,000 = $100,000 Allocation base: Square feet occupied

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Reciprocal Method Interdepartmental services are given full recognition rather than partial recognition as with the step method. Service Department (Cafeteria) Service Department (Custodial) Operating Department (Machining) Operating Department (Assembly) Because of its mathematical complexity, the reciprocal method is rarely used.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Revenue Producing Service Departments If a service department generates revenue, such as a cafeteria that charges for the service it provides, the revenue generated should be offset against the costs incurred. Only the remaining net amount of costs should be allocated to other departments.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check Data for Direct and Step Methods Allocation bases: Business school administration costs (ADMIN): Number of employees Business Administration computer services (BACS): Number of personal computers The direct method of allocation is used.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000 How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000 How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000 Quick Check $180,000 × = $36,000

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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 × = $13,500

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check Data Allocation bases: Business school administration costs (ADMIN): Number of employees Business administration computer services (BACS): Number of personal computers The step method of allocation is used.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Allocating Costs by Behavior When possible, variable and fixed service department costs should be allocated separately.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Variable service department costs should be allocated to consuming departments according to the activity causing incurrence of the cost. Allocating Costs by Behavior

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Allocate fixed service department costs to consuming departments in predetermined lump-sum amounts that are based on the consuming departments’ peak or long-run average needs. Fixed cost allocations: Are based on amounts of capacity each consuming department requires. Should not vary from period to period. Allocating Costs by Behavior

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Allocating Costs by Behavior Budgeted variable and fixed service department costs should be allocated to operating departments.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Allocating Costs by Behavior If variable cost allocations are made at the beginning of the year, the budgeted variable rate should be multiplied by the budgeted activity level of each consuming department. Allocations made at the beginning of the year provide data for pricing and other decisions.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Allocating Costs by Behavior If variable cost allocations are made at the end of the year, the budgeted variable rate should be multiplied by the actual activity level of each consuming department. Allocations made at the end of the year provide data for performance evaluation.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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. SimCo: An Example

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Hours planned SimCo: Beginning of the Year

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Percent of peak-period capacity. SimCo: Beginning of the Year Hours planned

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Hours used SimCo: End of the Year

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Percent of peak-period capacity. SimCo: End of the Year Hours used

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Fixed cost allocations are the same at the end and at the beginning because they are based on capacity instead of usage. SimCo: Comparison of Results

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin SimCo: Comparison of Results Only budgeted variable and fixed service department costs were allocated to the two operating departments. The cost of service department inefficiencies, contained in the actual costs, should not be passed along to operating departments.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check: Allocating Costs by Behavior 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:

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Effect of Allocations on Operating Departments Once service department cost allocations are completed, they are included in operating departments’: Performance evaluations Profitability determination Overhead rate computations

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin First Stage Allocations Service department costs are allocated to operating departments. Service Department (Cafeteria) Service Department (Accounting) Service Department (Personnel) Operating Department (Machining) Operating Department (Assembly) The Products Effect of Allocations on Operating Departments

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Service Department (Cafeteria) Service Department (Accounting) Service Department (Personnel) Operating Department (Machining) Operating Department (Assembly) The Products Second Stage Allocations Operating department overhead costs and allocated service department costs are applied to products. Effect of Allocations on Operating Departments

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Pitfall 1 Allocating fixed costs using a variable allocation base Allocation Pitfalls to Avoid Result Fixed costs allocated to one department are heavily influenced by what happens in other departments.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Kolby Products: An Example Kolby Products has two sales territories, the Eastern Territory and the Western Territory. Both sales territories are serviced by one auto service center whose costs are all fixed. Contrary to good practice, Kolby allocates the fixed service center costs to the sales territories on the basis of actual miles driven (a variable base).

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Kolby Products: An Example $120,000 ÷ 3,000,000 miles $120,000 ÷ 2,400,000 miles

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Kolby Products: First–year Allocations The two sales territories share the service center’s costs equally because the miles driven in each territory are equal.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Kolby Products: Second–year Allocation Western territory has the same number of miles as last year, but $15,000 more cost allocated because Eastern’s miles declined in year 2.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Pitfall 2 Using sales dollars as an allocation base Allocation Pitfalls to Avoid Result Sales of one department influence the service department costs allocated to other departments.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Clothier Inc. – An Example Clothier Inc., a men’s clothing store has one service department and three sales departments, Suits, Shoes, and Accessories. Service department costs total $60,000 for both years in the example. Contrary to good practice, Clothier allocates the service department costs based on sales.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Clothier Inc. – First-year Allocation $260,000 ÷ $400,000 65% of $60,000 In the next year, the manager of the Suit Department increased sales by $100,000. Sales in the other departments are unchanged. Let’s allocate the $60,000 service department cost for the second year given the sales increase.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Clothier Inc. – Second-year Allocation $360,000 ÷ $500,000 72% of $60,000 If you were the suit department manager, would you be happy with the increased service department costs allocated to your department?

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Chapter 15