1. Cost Allocation

2. 1. Describe how a costing system can have multiple cost objects 2. Outline four purposes for allocating costs to cost objects 3. Describe alternative criteria used to guide decisions related to cost allocations 4. Discuss key decisions faced when collecting costs in indirect cost pools Learning Objectives

3. 5. Describe how the single-rate cost-allocation method differs from the dual-rate method 6. Explain how the choice of budgeted versus actual allocation rates changes the risks managers face 7. Distinguish among direct allocation, step-down, and reciprocal methods of allocating support department costs 8. Distinguish between the incremental and stand- alone cost allocation methods Learning Objectives

4. Purposes of Cost Allocation 1. To provide information for economic decisions 2. To motivate managers and employees u To decide whether to add a new airline flight u To decide whether to make a component part of a television set or to purchase if from another manufacturer television set or to purchase if from another manufacturer u To decide on the selling price for a customized product or service service u To encourage the design of products that are simpler to manufacture or less costly to service manufacture or less costly to service u To encourage sales representatives to push high-margin products and services products and services

5. Purposes of Cost Allocation 3. To justify costs or compute reimbursement 4. To measure income and assets for meeting external regulatory and legal reporting obligations external regulatory and legal reporting obligations u To cost products at a “fair” prices, often done with government defense contracts government defense contracts u To compute reimbursement for a consulting firm u To cost inventories for financial reporting u To cost inventories for reporting to tax authorities

6. Allocating Costs of Support Departments S1S1 P3P3 P2P2 P1P1

7. Operating and Support Departments Operating (production) departments add value to a product or service that is observable by a customer. Support (service) departments provide the services that maintain other internal departments in the organization.

8. Methods to Allocate Support Department’s Costs  Direct allocation method  Step-down allocation method  Reciprocal allocation method

9. Data for Allocating Support Department Costs at Castleford Engineering for 20_7

10. Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated

11. Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated 30% 50% 20%

12. Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated 30% 50% 20%10% 80% 10%

13. Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining Not Allocated $0 $103,111 $12,889 $0 $225,000 $375,000 $116,000  10%/[80%+10%

14. Direct Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly$587,889 Machining$728,111 Not Allocated $0 $103,111 $12,889 $0 $225,000 $375,000 $116,000  10%/[80%+10%

15. Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000+Allocated Assembly Machining Not Allocated 30% 50% 10% 80% 10% 20%20%

16. Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000+$120,000 Assembly Machining Not Allocated $180,000 $300,000 $120,00010% 80% 10%

17. Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $236,000 Assembly$300,000 +$236,000  1/9 Machining$180,000 +$236,000  8/9 Not Allocated $180,000 $300,000 $120,00010% 80% 10%

18. Step-Down Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $236,000 Assembly$526,222 Machining$789,778 Not Allocated $180,000 $300,000 $120,00010% 80% 10%

19. Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $600,000 Information Systems $116,000 Assembly Machining 30% 50% 20%10% 80% 10%

20. Reciprocal Method SUPPORT DEPARTMENTS Plant Maintenance $600,000+Allocated Information Systems $116,000+Allocated 20%10% Let PM = total reciprocal cost of the Plant Maintenance Department Let IS = total reciprocal cost of the Information Systems Department PM = $600,000 + 0.1IS IS = $116,000 + 0.2PM Solving for PM and IS, PM = $624,082 IS = $240,816

21. Reciprocal Method SUPPORT DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Let PM = total reciprocal cost of the Plant Maintenance Department Let IS = total reciprocal cost of the Information Systems Department PM = $600,000 + 0.1IS IS = $116,000 + 0.2PM Solving for PM and IS, PM = $624,082 IS = $240,816

22. Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Assembly Machining 30% 50% 80% 10%

23. Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Assembly$312,041+$24,082 Machining$187,225+$192,652 30% 50% 80% 10% $624,082*(3/10)+$240,816*(8/10)

24. Reciprocal Method SUPPORT DEPARTMENTS OPERATING DEPARTMENTS Plant Maintenance $624,082 Information Systems $240,816 Assembly$536,123 Machining$779,877 30% 50% 80% 10%

25. Comparison of Methods ALLOCATED SERVICE DEPARTMENT COST METHODMachiningAssemblyTotal DIRECT$728,111$587,889$1,316,000 STEP$789,778$526,222 RECIPROCAL$779,877$536,123 Differences among the 3 methods’ allocations increase  as the magnitude of the reciprocal services increases, and  as the differences across operating departments’ usage of each support service increase. $1,316,000 $1,316,000

26. The reciprocal method, while conceptually preferable, is not widely used. Because (1) many managers find it difficult to understand, and to understand, and (2) the numbers obtained by using the reciprocal method differ little, in some reciprocal method differ little, in some cases, from those obtained by using the cases, from those obtained by using the direct or step-down method. direct or step-down method.

27. Allocation of Support Department Costs Method 1. Direct method 2. Step-down method 3. Reciprocal method 4. Other method 5. Not allocated Source: Blayney & Yokohama (1991) 43% 3 5153458%2710 1 464% 614 8 8 S U R V E Y S OF C O M P A N Y P R A C T I C E