1. Support Activity and Dual Rate Allocations
Chapter 16
Support Activity and Dual Rate Allocations

2. Line and Support Activities
A line activity is directly connected with making or selling a product
Machining, distribution
A support activity is needed to run the business (helps a line activity)
Not connected directly to making or selling a product
Human resources, accounting
Need to allocate costs of both line and staff activities to products
LO1: Distinguish between line activities and support activities

3. What Is The Problem? Most allocations are two-stage systems
We group costs into pools (stage 1). Pools can be departments, activities,….
We allocate from pools to cost objects (stage 2)
We have implicitly assumed (see next slide) a simple flow of costs (i.e., assume line activities only)
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

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

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

6. 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.

7. Test Your Knowledge!
Which of the following methods is not an acceptable method for allocating the cost of support activities?
The step-down method
The reciprocal method
The indirect method
The direct method

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

9. Direct Method
This method ignores any interaction among the cost pools for support activities
Note that cost pools for primary activities only go to the cost objects (by definition)
Do the allocation as if the support departments did not consume any output from another service department
Computation:
Re calculate 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.

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

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

12. Test Your Knowledge!
In a home construction company, support costs accumulated by the IT department can be allocated to all except which of the following departments when using the direct method?
Design
Electrical
Masonry
Purchasing

13. After eliminating consumption by administration, plumbing consumes 42
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%.

14. The Step-down method Concept Takes some account of interactions
Rank order 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.

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

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

17. Step-down method Also known as the sequential method
Departments are sequentially allocated
The ordering of support departments matters
Incentives to be strategic when choosing the order
Can change amount allocated to segments with cost-based reimbursements
LO2: Explain the three methods used to allocate the costs of support activities to products.

18. The Reciprocal Method Conceptually most accurate
Takes all linkages into account
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 the potential to confuse the casual user
LO2: Explain the three methods used to allocate the costs of support activities to products.

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

20. Mechanics Set up system of equation
A = $650, P
P = $250, A.
We solve this system of equations by substituting the second equation into the first equation.
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.

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

22. 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.

23. Why Integrate?
Helps sensitize managers that support services are not “free”
Provides incentives to control the 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.

24. Solution presented in next slide.

25. 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 (0.15 x $250,000) = $37,500 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 0.4 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.

26. Solution presented in next slide.

27. Solution for Check It Exercise #3
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.

28. DUAL RATE ALLOCATIONS
LO3: Explain the need for dual rate allocations

29. Why Needed? 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 costs (capacity costs) allocated based on long-term use patterns
LO3: Explain the need for dual rate allocations

30. 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: Explain the need for dual rate allocations

31. Why Separate?
We can send clear signals re the costs controllable over the differing horizons
Decisions regarding service use (which user-department managers control) based on more relevant data
The cost is system become more complex.
Incentives to game the “long-term” estimate
Under-estimate will lower lump sum allocation to user department
Affects the amount of capacity to install
LO3: Explain the need for dual rate allocations

32. Exercise 16.21 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.

33. Exercise 16.21 (Continued) Direct method (LO2).
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.
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.

34. 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.

35. General Administration
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 Resources1
50%
General
Administration2
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.

36. 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 Resources1
(100,000)
50,000
General
Administration2
(60,000)
45,000
15,000
Total
$455,000
$515,000
1 50,000 = 0.50 × $100,000.
2 $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.