1. Agenda Service department cost allocations The downward demand spiral

2. Agenda Service department cost allocations The downward demand spiral

3. Overview of Costing for Manufacturing Companies

4. Allocation of Service Department Costs Data Processing Accounting Human Resources Factories Warehouses

5. Allocation of Service Department Costs THE DIRECT METHOD The Roswell and El Paso factories are the only production departments using services from the Accounting department. On a relative basis, Roswell and El Paso use 60% and 40% of the Accounting department’s services, respectively. The Accounting department has total costs of $82,000. Roswell and El Paso are allocated $49,200 and $32,800 of the Accounting department’s costs.

6. Allocation of Service Department Costs Data Processing Accounting Human Resources Roswell Factory El Paso Factory 60%40% $82,000 $82,000 x 60% = $49,200 $82,000 x 40% = $32,800

7. Allocation of Service Department Costs Data Processing Accounting Human Resources Roswell El Paso 30%20% 25% $82,000 $82,000 x 60% = $49,200 $82,000 x 40% = $32,800 30%__ 30% + 20% = 60% 20%__ 30% + 20% = 40%

8. Some Choices in how to Allocate Service Department Costs Service department costs can be allocated using budgeted rates or actual rates. –Advantages of using budgeted rates: facilitates planning encourages cost control –Advantages of using actual rates: always allocates all costs.

9. Fixed costs can be allocated separately from variable costs. Some companies don’t allocate service department costs at all. Some Choices in how to Allocate Service Department Costs

10. Example Maintenance Department Costs for the year: Static budget Flexible budget Actual Variable: $5 per hour $200,000 $150,000 $5.10 per hour $153,000 Fixed 75,000 75,000 79,500 Totals $275,000 $225,000 $232,500

11. Example Hr.s of maintenance service used Operating dept Budgeted Actual Fabrication 20,000 20,000 Assembly 20,000 10,000 Total 40,000 30,000 Let’s allocate using a dual rate: - Variable costs using budgeted rates & actual use - Fixed costs using budgeted amounts and expected long-term use.

12. Example The budgeted rate for variable costs is $5 per hour. Fabrication: $5/hr x 20K actual hrs = $100,000 Assembly: $5/hr x 10K actual hrs = $50,000 Total $$ allocated: $100K + $50K = $150,000 Actual variable costs incurred: $153,000 Amount not allocated: $3,000

13. Example Assume estimated long-term use is 60% for Fabrication and 40% for Assembly. Recall budgeted fixed costs were $75,000. Fabrication: 60% of $75,000 = $45,000 Assembly: 40% of $75,000 = $30,000 Total $$ allocated: = $75,000 Actual fixed costs incurred: $79,500 Amount not allocated: $4,500

14. Advantages of allocating costs this way Managers do not absorb the inefficiencies of the Maintenance Dept, because budgeted rates are used. The allocation to each department is not affected by the use of other departments. Operating managers probably will not overuse the service, because there is a charge for it. Operating managers probably will ignore the allocation of fixed costs, because the allocation of fixed costs does not depend on short-term actual use.

15. Allocation of Service Department Costs Other Methods to Allocate Service Department Costs –Step-down Method Captures some of the interaction among service departments –Reciprocal Method Captures all of the interaction among service departments Also called the simultaneous method

16. Step-Down Method The step-down method is also called the sequential method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it.

17. Step-Down Method Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other. The company decides to allocate H.R. first, because it provides services to two other service departments, and provides a greater percentage of its services to other service departments. The company allocates data processing second, and Risk Management last.

18. Step-Down Method Ser- vice Dept Total Cost Percentage of services provided by the service department listed at left to: H.R.D.P.R.M.Machiningassembly H.R. $80,00020%10%40%30% D.P. $120,0008%7%30%55% R.M. $40,00050% $240,000

19. Step-Down Method H.R.D.P.R.M.machiningassembly Costs prior to allocation $80,000$120,000$40,000 Allocation of H.R. 80,000 16,0008,000$32,000$24,000 Allocation of D.P. 136,000 10,34844,34881,304 Allocation of R.M. 58,348 29,174 000$105,522$134,478

20. Reciprocal Method The reciprocal method is the most accurate method for allocating service department costs. It recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations.

21. Reciprocal Method Ser- vice Dept Total Cost Percentage of services provided by the service department listed at left to: H.R.D.P.R.M.Machiningassembly H.R. $80,00020%10%40%30% D.P. $120,0008%7%30%55% R.M. $40,00050% $240,000 The simultaneous equations are: H.R. = $ 80,000 + (0.08 x D.P.) D.P. = $120,000 + (0.20 x H.R.) R.M. = $ 40,000 + (0.10 x H.R.) + (0.07 x D.P.)

22. Reciprocal Method The simultaneous equations are: H.R. = $ 80,000 + (0.08 x D.P.) D.P. = $120,000 + (0.20 x H.R.) R.M. = $ 40,000 + (0.10 x H.R.) + (0.07 x D.P.) Solving for three equations in three unknowns: H.R. = $ 91,057 D.P. = $138,211 R.M. = $ 58,781

23. Reciprocal Method H.R.D.P.R.M. machiningassembly Costs prior to allocation $80,000$120,000$40,000 Allocation of H.R. 91,057 18,2119,106$36,423$27,317 Allocation of D.P. 11,057 138,211 9,67541,46376,016 Allocation of R.M. 58,781 29,390 000$107,276$132,723 Solving for three equations in three unknowns: H.R. = $ 91,057 D.P. = $138,211 R.M. = $ 58,781

24. Agenda Service department cost allocations The downward demand spiral

25. The Downward Demand Spiral

26. The printing department of a large manufacturing company provides in-house printing services for the company’s operating divisions. The printing department is treated as a profit center. It has fixed costs of $1,000 per month. It has average variable costs of $50 per print job. There are 20 managers in the operating divisions who each require one print job per month. These managers can hire the in-house printing department, or can outsource their print jobs to outside vendors.

27. The Downward Demand Spiral The manager of the printing department wants to set a price per print job in order to break even (show zero departmental profits). Recall the cost-volume-profit equation: Profit + F.C. = Quantity x (sales price – variable cost)

28. The Downward Demand Spiral The manager of the printing department wants to set a price per print job in order to show profits of $400 for the month. Recall the cost-volume-profit equation: Profit + F.C. = Quantity x (sales price – variable cost)