Cost Allocations of Service Departments

2. Cost Allocations of Service Departments Chapter 6

3. Cost Allocation and Charges for Services Rendered • Intracompany – inside the same entity • This chapter will cover • reasons for establishment of an internal service charging system or to have an cost allocation system • techniques and principles of allocation to be used • allocation of service department costs to operating departments using the direct and step-down methods

4. Cost Allocation and Charges for Services Rendered • Intercompany – different entities within the same group • Transfer pricing • may help group’s tax planning • may be monitored and scrutinized by tax authorities and other interested regulating bodies/agents. • needs to be seen as an “arm’s length transaction” • Will be covered in Chapter 13 Appendix A

5. Learning Objective 1 Explain the major reasons for the need for allocating nonmanufacturing costs.

6. Service Department Charges Operating Departments Service Departments Carry out central purposes of organization. Do not directly engage in operating activities.

7. Reasons for Charging Service Department Costs Service department costs are charged to operating departments for a variety of reasons including: 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 an incentive for service departments to operate efficiently.

8. Management Needs • Need to understand the full cost of providing a product or service (including supporting costs) to make better decisions. • Ensuring competitive costing and pricing • Assessment of risk and potential success of the product/service • Financial and operational forecasts and planning • Motivating performance evaluation and reward system • Communicating to employees about the importance of recovering all indirect costs • Encouraging efficient and effective use of resources • Ensuring long-term sustainability and competitiveness

9. $ ServiceDepartments OperatingDepartments Transfer Prices The service department charges considered can be viewed as a transfer price that is charged for services provided by service departments to operating departments/companies within the group.

10. Factors to be Considered in the Cost Allocation Approach and Intercompany/Interdepartmental charges • Cost-benefit Evaluation • Including tangible and intangible costs and benefits • Cause and effect • Absorption of cost based on who causes it • Benefit Received • Absorption of cost based on the ultimate benefactor • Ability to Bear • Absorption of cost based on who/which product has the ability and profit margin to bear the cost • Fairness or Equity • Ensuring fair game and decent profit to motive service provider, for example, use of a cost-plus performance based award fee approach, to ensure quality delivery of service/product

11. Service Department Charges

12. Learning Objective 2 Allocate costs of service departments to other operating departments/units using the cost behavior concept.

13. Charging Costs by Behavior Whenever possible,variable and fixedservice department costsshould be chargedseparately.

14. Charging Costs by Behavior Variable servicedepartment costs should becharged to consuming departmentsaccording to whatever activitycauses the incurrence of the cost.

15. Charging Costs by Behavior Charge fixed service department costs to consuming departments in predetermined lump-sum amounts that are based on the consuming department’s peak-period or long-run average servicing needs. Are based on amounts ofcapacity each consumingdepartment requires. Should not vary fromperiod to period.

16. Should Actual or Budgeted Costs Be Charged? Budgeted variableand fixed service departmentcosts should be charged tooperating departments.

17. Sipco: An Example Sipco has a maintenance department and two operatingdepartments: Cutting and Assembly. Variable maintenancecosts are budgeted at $0.60 per machine hour. Fixedmaintenance costs are budgeted at $200,000 per year.Data relating to the current year are: Allocate maintenance costs to the two operating departments.

18. Actual hours Sipco: End of the Year

19. Actual hours Percent of peak-period capacity. Sipco: End of the Year

20. Quick Check  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:

21. Quick Check  How much ambulance service cost will be allocated to Mercy Hospital at the endof the year? a. $121,200 b. $254,400 c. $139,500 d. $117,000

22. Quick Check  How much ambulance service cost will be allocated to Mercy Hospital at the end of the year? a. $121,200 b. $254,400 c. $139,500 d. $117,000

23. Result Fixed costsallocated to onedepartment areheavily influenced bywhat happens in other departments. Pitfalls in Allocating Fixed Costs Allocating fixed costs using a variableallocation base.

24. Result Sales of one departmentinfluence the servicedepartment costsallocated to otherdepartments. Pitfalls in Allocating Fixed Costs Using salesdollars as anallocation base.

25. Autos R Us – An Example Autos R Us has one service department and three sales departments, New Cars, Used Cars, and Car Parts. The service department costs total $80,000 for both years in the example. Contrary to good practice, Autos R Us allocates theservice department costs based on sales.

26. 50% of $80,000 $1,500,000 ÷ $3,000,000 Autos R Us – First-year Allocation In the next year, the manager of the New Cars departmentincreases sales by $500,000. Sales in the other departmentsare unchanged. Let’s allocate the $80,000 service departmentcost for the second year given the sales increase.

27. 57% of $80,000 $2,000,000 ÷ $3,500,000 Autos R Us – Second-year Allocation If you were the manager of the New Cars department, wouldyou be happy with the increased service departmentcosts allocated to your department?

28. Service Department Allocations

29. Operating Departments Anoperating department carries out the central purpose of the organization The Geography Department at the University of Washington. The Surgery Department at Mount Sinai Hospital. A Production Department at Mitsubishi.

30. Service Departments Service departments do not directly engage in operating activities. The Accounting Department at Macy’s. The Human Resources Department at Walgreens.

31. Interdepartmental Services ServiceDepartment OperatingDepartment Costs of the service department become overhead costs to the operating department

32.  DirectMethod  Step-DownMethod  ReciprocalMethod Allocation Approaches

33. Reciprocal Services ServiceDepartment 1 ServiceDepartment 2 When service departments provide services to each other we call them reciprocal services.

34. Learning Objective 3 Allocate service department costs to operating departments using the direct method.

35. Interactionsbetween service departments areignored and all costs areallocated directlyto operatingdepartments. Direct Method Service Department (Cafeteria) Operating Department (Machining) Service Department (Custodial) Operating Department (Assembly)

36. Direct Method – An Example

37. Direct Method – An Example How much of the Cafeteria and Custodial costs should be allocated to each operating department using the direct method of cost allocation?

38. 20 20 + 30 $360,000 × = $144,000 Direct Method – An Example Allocation base: Number of employees

39. 30 20 + 30 $360,000 × = $216,000 Direct Method – An Example Allocation base: Number of employees

40. 25,000 25,000 + 50,000 $90,000 × = $30,000 Direct Method – An Example Allocation base: Square feet occupied

41. 50,000 25,000 + 50,000 $90,000 × = $60,000 Direct Method – An Example Allocation base: Square feet occupied

42. Learning Objective 4 To allocate service department costs to operating departments using the step-down method.

43. Once a servicedepartment’s costsare allocated, other servicedepartment costsare not allocatedback to it. Step-Down Method Service Department (Cafeteria) Operating Department (Machining) Service Department (Custodial) Operating Department (Assembly)

44. Step-Down Method There are three key points to understand regarding the step-down method: In both the direct and step-down 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.

45. Step-Down Method – An Example We will use the same data used in the direct method example.

46. Step-Down Method – An Example Allocate Cafeteria costs first sinceit provides more service than Custodial.

47. 10 10 + 20 + 30 $360,000 × = $60,000 Allocation base: Number of employees Step-Down Method – An Example

48. 20 10 + 20 + 30 $360,000 × = $120,000 Allocation base: Number of employees Step-Down Method – An Example

49. 30 10 + 20 + 30 $360,000 × = $180,000 Allocation base: Number of employees Step-Down Method – An Example

50. New total = $90,000 original Custodial cost plus $60,000 allocated from the Cafeteria. Step-Down Method – An Example