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11 th Edition Chapter 15. Service Department Costing: An Activity Approach. Chapter Fifteen. Reasons for Allocating Service Department Costs. To encourage operating departments to wisely use service department resources.

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11 th Edition Chapter 15


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reasons for allocating service department costs
Reasons for Allocating Service Department Costs

To encourage operatingdepartments to wiselyuse service departmentresources.

To provide operatingdepartments with morecomplete cost datafor making decisions.

To help measure theprofitability of operatingdepartments.

To create incentivefor service departmentsto operate efficiently.

To value inventory for external financialreporting purposes.

To include all overheadin the cost base when cost-plus pricing is used.

selecting allocation bases

$

ServiceDepartments

OperatingDepartments

Selecting Allocation Bases

The allocation bases used should“drive” the cost being allocated.

For example, when allocating costsof the employee cafeteria, the numberof meals served would be a goodchoice for the allocation base.

selecting allocation bases1

$

ServiceDepartments

OperatingDepartments

Selecting Allocation Bases

A service department’s costs may beallocated using more than one base.

For example, a portion of the human resource departmentcosts might be allocated based on the number of employeesin each operating department and another portion might beallocated based on hours spent in training employees ineach operating department.

interdepartmental services
Interdepartmental Services

Problem

Allocating costs when service departmentsprovide services to each other

Solutions

Direct Method

Step Method

Reciprocal Method

direct method

Interactionsbetween service

departments areignored and all

costs areallocated directlyto operatingdepartments.

Direct Method

Service Department

(Cafeteria)

Operating Department

(Machining)

Service Department

(Custodial)

Operating Department

(Assembly)

direct method example2

20

20 + 30

$360,000 ×

= $144,000

Direct Method Example

Allocation base: Number of employees

direct method example3

30

20 + 30

$360,000 ×

= $216,000

Direct Method Example

Allocation base: Number of employees

direct method example4

25,000

25,000 + 50,000

$90,000 ×

= $30,000

Direct Method Example

Allocation base: Square feet occupied

direct method example5

50,000

25,000 + 50,000

$90,000 ×

= $60,000

Direct Method Example

Allocation base: Square feet occupied

step method

Once a servicedepartment’s costsare allocated, other servicedepartment costsare not allocatedback to it.

Step Method

Service Department

(Cafeteria)

Operating Department

(Machining)

Service Department

(Custodial)

Operating Department

(Assembly)

step method1
Step Method

There are three key points to understand regarding the step method:

 In both the direct and step 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.

step method example
Step Method Example

We will use the same data used in the direct method example.

step method example1
Step Method Example

Allocate Cafeteria costs first sinceit provides more service than Custodial.

step method example2

10

10 + 20 + 30

$360,000 ×

= $60,000

Allocation base: Number of employees

Step Method Example
step method example3

20

10 + 20 + 30

$360,000 ×

= $120,000

Allocation base: Number of employees

Step Method Example
step method example4

30

10 + 20 + 30

$360,000 ×

= $180,000

Allocation base: Number of employees

Step Method Example
step method example6

25,000

25,000 + 50,000

$150,000 ×

= $50,000

Allocation base: Square feet occupied

Step Method Example
step method example7

50,000

25,000 + 50,000

$150,000 ×

= $100,000

Allocation base: Square feet occupied

Step Method Example
reciprocal method

Interdepartmentalservices are givenfull recognitionrather than partialrecognition as withthe step method.

Reciprocal Method

Service Department

(Cafeteria)

Operating Department

(Machining)

Service Department

(Custodial)

Operating Department

(Assembly)

Because of its mathematical complexity, the reciprocal method is rarely used.

revenue producing service departments
Revenue Producing Service Departments

If a service departmentgenerates revenue, such as acafeteria that charges for the service itprovides, the revenue generated shouldbe offset against the costs incurred.Only the remaining net amountof costs should be allocated to other departments.

quick check data for direct and step methods
Quick Check Datafor Direct and Step Methods

The direct method of allocation is used.

  • Allocation bases:
    • Business school administration costs (ADMIN): Number of employees
    • Business Administration computer services (BACS): Number of personal computers
quick check
Quick Check 

How much cost will be allocated from Administration to Accounting?

a. $ 36,000

b. $144,000

c. $180,000

d. $ 27,000

quick check1

20

20 + 80

$180,000 ×

= $36,000

Quick Check 

How much cost will be allocated from Administration to Accounting?

a. $ 36,000

b. $144,000

c. $180,000

d. $ 27,000

quick check2
Quick Check 

How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?

a. $ 52,500

b. $135,000

c. $270,000

d. $ 49,500

quick check3

18

18 + 102

$90,000 ×

= $13,500

Quick Check 

How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?

a. $ 52,500

b. $135,000

c. $270,000

d. $ 49,500

quick check data
Quick Check Data

The step method of allocation is used.

  • Allocation bases:
    • Business school administration costs (ADMIN): Number of employees
    • Business administration computer services (BACS): Number of personal computers
quick check4
Quick Check 

How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?

a. $35,250

b. $49,072

c. $18,000

d. $26,333

quick check5
Quick Check 

How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?

a. $35,250

b. $49,072

c. $18,000

d. $26,333

allocating costs by behavior
Allocating Costs by Behavior

When possible,variable and fixedservice department costsshould be allocatedseparately.

allocating costs by behavior1
Allocating Costs by Behavior

Variable servicedepartment costs should beallocated to consuming departmentsaccording to the activitycausing incurrence of the cost.

allocating costs by behavior2
Allocating Costs by Behavior

Allocate fixed service department costs to consuming departments in predeterminedlump-sum amounts that are based on theconsuming departments’ peak or long-runaverage needs. Fixed cost allocations:

Are based on amounts ofcapacity each consumingdepartment requires.

Should not vary fromperiod to period.

allocating costs by behavior3
Allocating Costs by Behavior

Budgeted variableand fixed service departmentcosts should be allocated tooperating departments.

allocating costs by behavior4
Allocating Costs by Behavior

If variable cost allocations are made at thebeginning of the year, the budgeted variablerate should be multiplied by the budgetedactivity level of each consuming department.

Allocations madeat the beginning of theyear provide data forpricing and otherdecisions.

allocating costs by behavior5
Allocating Costs by Behavior

If variablecost allocations are made at theendof the year, thebudgeted variablerate should be multiplied by theactualactivity level of each consuming department.

Allocations made atthe end of the year providedata for performanceevaluation.

simco an example
SimCo: An Example

SimCo 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.

simco beginning of the year1

Hours planned

Percent of peak-period capacity.

SimCo: Beginning of the Year
simco end of the year1

Hours used

Percent of peak-period capacity.

SimCo: End of the Year
simco comparison of results
SimCo: Comparison of Results

Fixed cost allocations are the same at the end and at the beginning because they are based on capacity instead of usage.

simco comparison of results1
SimCo: Comparison of Results

Only budgeted variable and fixed servicedepartment costs were allocated to the two operating departments.The cost of service department inefficiencies,contained in the actual costs, should notbe passed along to operating departments.

quick check allocating costs by behavior
Quick Check:Allocating Costs by Behavior

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:

quick check6
Quick Check 

How much ambulance service cost will be allocated to Mercy Hospital at the beginning of the year?

a. $117,000

b. $254,400

c. $114,480

d. $119,250

quick check7
Quick Check 

How much ambulance service cost will be allocated to Mercy Hospital at the beginning of the year?

a. $117,000

b. $254,400

c. $114,480

d. $119,250

quick check8
Quick Check 

How much ambulance service cost will be allocated to Mercy Hospital at the end of the year?

a. $114,000

b. $118,800

c. $110,400

d. $121,200

quick check9
Quick Check 

How much ambulance service cost will be allocated to Mercy Hospital at the end of the year?

a. $114,000

b. $118,800

c. $110,400

d. $121,200

effect of allocations on operating departments
Effect of Allocations onOperating Departments

Once service department costallocations are completed, they areincluded in operating departments’:

Performanceevaluations

Profitabilitydetermination

Overhead rate computations

effect of allocations on operating departments1

First Stage Allocations

Service department costs are allocated to operating departments.

Effect of Allocations onOperating Departments

Service Department

(Cafeteria)

Operating Department

(Machining)

Service Department

(Accounting)

The Products

Operating Department

(Assembly)

Service Department

(Personnel)

effect of allocations on operating departments2

Second Stage Allocations

Operating department overhead costs and allocated service department costs are applied to products.

Effect of Allocations onOperating Departments

Service Department

(Cafeteria)

Operating Department

(Machining)

Service Department

(Accounting)

The Products

Operating Department

(Assembly)

Service Department

(Personnel)

allocation pitfalls to avoid

Result

Fixed costsallocated to onedepartment areheavily influenced bywhat happens in other departments.

Allocation Pitfalls to Avoid

Pitfall 1

Allocating fixed costs using a variableallocation base

kolby products an example
Kolby Products: An Example

Kolby Products has two sales territories,the Eastern Territory and the Western Territory. Both sales territories are serviced by one auto service center whose costs are all fixed. Contraryto good practice, Kolby allocates the fixed servicecenter costs to the sales territories on the basisof actual miles driven (a variable base).

kolby products first year allocations
Kolby Products:First–year Allocations

The two sales territories share the servicecenter’s costs equally because the milesdriven in each territory are equal.

kolby products second year allocation
Kolby Products:Second–year Allocation

Western territory has the same number of miles aslast year, but $15,000 more cost allocatedbecause Eastern’s miles declined in year 2.

allocation pitfalls to avoid1

Result

Sales of one departmentinfluence the servicedepartment costsallocated to otherdepartments.

Allocation Pitfalls to Avoid

Pitfall 2

Using salesdollars as anallocation base

clothier inc an example
Clothier Inc. – An Example

Clothier Inc., a men’s clothing store has oneservice department and three sales departments,Suits, Shoes, and Accessories. Service departmentcosts total $60,000 for both years in the example.Contrary to good practice, Clothier allocates theservice department costs based on sales.

clothier inc first year allocation

65% of $60,000

$260,000 ÷ $400,000

Clothier Inc. – First-year Allocation

In the next year, the manager of the Suit Departmentincreased sales by $100,000. Sales in the other departmentsare unchanged. Let’s allocate the $60,000 service departmentcost for the second year given the sales increase.

clothier inc second year allocation

72% of $60,000

$360,000 ÷ $500,000

Clothier Inc. – Second-year Allocation

If you were the suit department manager, wouldyou be happy with the increased service departmentcosts allocated to your department?