© 2012 Pearson Prentice Hall. All rights reserved. Allocation of Support Department Costs, Common Costs, and Revenues Edited for ACCT 7310 by Dr. Bailey

© 2012 Pearson Prentice Hall. All rights reserved. Cost allocation is important topic Recent Survey of AICPA & IMA members ranks overhead allocation as one of the most important topics that we should cover.

© 2012 Pearson Prentice Hall. All rights reserved. Purposes of Cost Allocation (from Ch. 14)

© 2012 Pearson Prentice Hall. All rights reserved. Criteria for Cost-Allocation Decisions (from Ch. 14) Cause-and-effect—variables are identified that cause resources to be consumed. Most credible to operating managers Integral part of ABC Benefits received—the beneficiaries of the outputs of the cost object are charged with costs in proportion to the benefits received. [continued…]

© 2012 Pearson Prentice Hall. All rights reserved. Criteria for Cost-Allocation Decisions (from Ch. 14) Fairness (equity)—the basis for establishing a price satisfactory to the government and its suppliers. Cost allocation here is viewed as a “reasonable” or “fair” means of establishing selling price. Ability to bear—costs are allocated in proportion to the cost object’s ability to bear them. Generally, larger or more profitable objects receive proportionally more of the allocated costs.

© 2012 Pearson Prentice Hall. All rights reserved. Allocating Costs of a Supporting Department to Operating Departments Supporting (service) department—provides the services that assist other internal departments in the company Operating (production) department—directly adds value to a product or service

© 2012 Pearson Prentice Hall. All rights reserved. Methods to Allocate Support Department Costs Single-rate method—allocates costs in each cost pool (service department) to cost objects (production departments) using the same rate per unit of a single allocation base No distinction is made between fixed and variable costs in this method.

© 2012 Pearson Prentice Hall. All rights reserved. Methods to Allocate Support Department Costs Dual-rate method—segregates costs within each cost pool into two segments: a variable-cost pool and a fixed-cost pool. Each pool uses a different cost-allocation base.

© 2012 Pearson Prentice Hall. All rights reserved. Allocation Method Trade-Offs Single-rate method is simple to implement, but treats fixed costs in a manner similar to variable costs. Dual-rate method treats fixed and variable costs more realistically, but is more complex to implement.

© 2012 Pearson Prentice Hall. All rights reserved. Allocation Bases Under either method, allocation of support costs can be based on one of the three following scenarios: 1. Budgeted overhead rate and budgeted hours 2. Budgeted overhead rate and actual hours 3. Actual overhead rate and actual hours Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, whereas actual will not be known with certainty until the end of the period

© 2012 Pearson Prentice Hall. All rights reserved. Exh. 15-1: Effects of variation in actual usage on fixed cost allocation (Discussion pp ) Allocations using budgeted rates, actual hours Allocating the total amt based on proportion of actual usage causes each division’s cost to depend on the other division’s usage!

© 2012 Pearson Prentice Hall. All rights reserved. Methods of Allocating Support Costs to Production Departments 1. Direct 2. Step-down 3. Reciprocal

© 2012 Pearson Prentice Hall. All rights reserved. Direct, step, reciprocal?

© 2012 Pearson Prentice Hall. All rights reserved. Direct method ignores support- department services to each other

© 2012 Pearson Prentice Hall. All rights reserved. Step considers some of the services between depts

© 2012 Pearson Prentice Hall. All rights reserved. Reciprocal considers them all

© 2012 Pearson Prentice Hall. All rights reserved. Allocating Common Costs Common cost—the cost of operating a facility, activity, or like cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user.

© 2012 Pearson Prentice Hall. All rights reserved. Methods of Allocating Common Costs Stand-alone cost-allocation method—uses information pertaining to each user of a cost object as a separate entity to determine the cost-allocation weights. Individual costs are added together and allocation percentages are calculated from the whole, and applied to the common cost.

© 2012 Pearson Prentice Hall. All rights reserved. Methods of Allocating Common Costs Incremental cost-allocation method ranks the individual users of a cost object in the order of users most responsible for a common cost and then uses this ranking to allocate the cost among the users. The first ranked user is the primary user and is allocated costs up the cost as a stand-alone user (typically gets the highest allocation of the common costs). The second ranked user is the first incremental user and is allocated the additional cost that arises from two users rather than one. Subsequent users are handled in the same manner as the second ranked user.

© 2012 Pearson Prentice Hall. All rights reserved. Revenue Allocation and Bundled Products Revenue allocation occurs when revenues are related to a particular revenue object but cannot be traced to it in an economically feasible manner. Revenue object—anything for which a separate measurement of revenue is desired. Bundled product—a package of two or more products or services that are sold for single price, but individual components of the bundle also may be sold as separate items at their own “stand-alone” prices.

© 2012 Pearson Prentice Hall. All rights reserved. Methods to Allocate Revenue to Bundled Products Stand-alone (separate) revenue allocation method uses product-specific information on the products in the bundle as weights for allocating the bundled revenues to the individual products. Three types of weights may be used: 1. Selling prices 2. Unit costs 3. Physical units

© 2012 Pearson Prentice Hall. All rights reserved. Methods to Allocate Revenue to Bundled Products Incremental revenue-allocation method ranks individual products in a bundle according to criteria determined by management and then uses this ranking to allocate bundled revenues to individual products (similar to earlier discussed incremental cost-allocation method). The first-ranked product is the primary product. The second-ranked product is the first incremental product. The third-ranked product is the second incremental product, and so on.

© 2012 Pearson Prentice Hall. All rights reserved. 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.

© 2012 Pearson Prentice Hall. All rights reserved. Revenues and Bundled Products What businesses provide bundled products? BanksHotelsTours  Checking  Safety deposit boxes  Investment advisory  Lodging  Food and beverage services  Recreation  Transportation  Lodging  Guides

© 2012 Pearson Prentice Hall. All rights reserved. Revenue Allocation Methods English Languages Institute buys English language software programs 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.

© 2012 Pearson Prentice Hall. All rights reserved. Revenue Allocation Methods Stand-alonePrice Grammar$255 Translation$ 85 Composition$185 Purchasing these software programs costs English the following: Grammar$180 Translation$ 45 Composition$ 95

© 2012 Pearson Prentice Hall. All rights reserved. Revenue Allocation Methods Bundle (Suites)Price Grammar + Translation$290 Grammar + Composition$350 Grammar + Translation + Composition$410

© 2012 Pearson Prentice Hall. All rights reserved. Revenue Allocation Methods The two main revenue allocation methods are: 1. The stand-alone method 2. The incremental method

© 2012 Pearson Prentice Hall. All rights reserved. Stand-Alone Revenue Allocation Method There are four types of weights for the stand-alone revenue allocation method. 1. Selling prices2. Unit costs 3. Physical units

© 2012 Pearson Prentice Hall. All rights reserved. Stand-Alone Revenue Allocation Method Consider the Grammar and Translation suite, which sells for $290. How much weight should English Languages Institute assign to each item?

© 2012 Pearson Prentice Hall. All rights reserved. Stand-Alone Revenue Allocation Method Selling prices: The individual selling prices are $255 for Grammar and $85 for Translation. $ = $340 total, so… Grammar: $255 ÷ $340 = 0.75, $290 bundle SP × 0.75 = $ Translation: $85 ÷ $340 = 0.25, $290 × 0.25 = $72.50

© 2012 Pearson Prentice Hall. All rights reserved. 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

© 2012 Pearson Prentice Hall. All rights reserved. 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

© 2012 Pearson Prentice Hall. All rights reserved. Stand-Alone Revenue Allocation Method Revenue Allocation Weights Grammar Translation Selling prices$217.50$ Unit costs Physical units

© 2012 Pearson Prentice Hall. All rights reserved. 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.

© 2012 Pearson Prentice Hall. All rights reserved. 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.

© 2012 Pearson Prentice Hall. All rights reserved. Incremental Revenue Allocation Method Grammar and Translation suite selling price = $290 Allocated to Grammar: $255 Remaining to be allocated: ($290 – $255) = $35 Allocated to Translation: $35

© 2012 Pearson Prentice Hall. All rights reserved. The End