Allocation of Support-Department Costs, Common Costs, and Revenues

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1 1 Allocation of Support-Department Costs, Common Costs, and Revenues A support department, also called a service department, provides the services that assist other internal departments (operating departments and other support departments) in the company. Examples of support departments are information systems and plant maintenance. Managers face two questions when allocating the costs of a support department to operating departments or divisions: (1) should fixed costs of support departments be allocated to operating divisions? (2) If fixed costs are allocated, should variable and fixed costs be allocated in the same way? With regard to the first question, most companies believe that fixed costs of support departments should be allocated because the support department needs to incur fixed costs to provide operating divisions with the services they require. Depending on the answer to the second question, there are two approaches to allocating support-department costs: the single-rate cost-allocation method and the dual-rate cost-allocation method. LO 1: Differentiate the single-rate allocation method from the dual-rate cost- The single-rate cost allocation method pool. pools together all costs in a cost The dual-rate cost allocation method classifies costs in each cost pool into Two cost pools a variable-cost pool and a fixed-cost pool.

2 2 EX Single-rate versus dual-rate methods, support department. The Chicago power plant that services all manufacturing departments of MidWest Engineering has a budget for the coming year. This budget has been expressed in the following monthly terms: Manufacturing Department Needed at Practical Capacity Production Level (Kilowatt-Hours) Average Expected Monthly Usage (Kilowatt-Hours) Rockford 10,000 8,000 Peoria 20,000 9,000 Hammond 12,000 7,000 Kankakee 8,000 6,000 Total 50,000 30,000 * The expected monthly costs for operating the power plant during the budget year are $15,000: $6,000 variable and $9,000 fixed. Required 1. Assume that a single cost pool is used for the power plant costs. What budgeted amounts will be allocated to each manufacturing department if (a) the rate is calculated based on practical capacity and costs are allocated based on practical capacity, and (b) the rate is calculated based on expected monthly usage and costs are allocated based on expected monthly usage? 2. Assume the dual-rate method is used with separate cost pools for the variable and fixed costs. Variable costs are allocated on the basis of expected monthly usage. Fixed costs are allocated on the basis of practical capacity. What budgeted amounts will be allocated to each manufacturing department? Why might you prefer the dual-rate method? Answer: 1a. * Practical capacity : Rockford 10,000 Peoria 20,000 Hammon 12,000 Kankakee 8,000 (Total 50,000) *Expected monthly usage : Rockford 8,000 Peoria 9,000 Hammon 7,000 Kankakee 6,000 (Total 30,000) Single-rate method based on practical capacity: Total costs in pool : 6, ,000 = $ 15,000 Total Practical capacity : 50,000 Kilowatt hours Allocation rate : $15,000 / 50,000 = $ 0.30 per hour of capacity

3 3 1b. *Practical capacity : Rockford 10,000 Peoria 20,000 Hammon 12,000 Kankakee 8,000 (Total 50,000) * Costs allocation at $0.30 per hour : Rockford : 0.30 * 10,000 = 3,000 Rockford 3,000 Peoria 6,000 Hammon 3,600 Kankakee 2,400 (Total 15,000) Single-rate method based on expected monthly usage : *Total costs in pool : 6, ,000 = $ 15,000 *Total expected monthly usage : 30,000 Kilowatt hours *Allocation rate : 15,000 / 30,000 = $ 0.50 per hour of expected usage 2. *Expected monthly usage : Rockford 8,000 Peoria 9,000 Hammon 7,000 Kankakee 6,000 (Total 30,000) * Costs allocation at $0.50 per hour : Rockford 0.50 * 8,000=4,000 Rockford 4,000 Peoria 4,500 Hammon 3,500 Kankakee 3,000 (Total 15,000) *Variable cost Pool : * Total cost in pool : 6,000 * Expected usage : 30,000 Kilowatt hours *Allocation rate : 6,000 / 30,000 = 0.20 per hour of expected usage

4 4 *Fixed cost pool : * Total cost in pool : 9,000 *Total Practical capacity : 50,000 Kilowatt hours * Allocation rate : $9000 / 50,000 = 0.18 per hour of capacity * Variable cost pool : ($0.20 * 8,000, 9,000, 7000, 6000 ) Rockford 1,600 Peoria 1,800 Hammon 1,400 Kankakee 1,200 (Total 6,000) * Fixed cost pool : ($0.18 * 10,000, 20,000, 12,000, 8,000 ) Rockford 1,800 Peoria 3,600 Hammon 2,160 Kankakee 1,440 (Total 9,000) Total : Rockford 3,400 Peoria 5,400 Hammon 3,560 Kankakee 2,640 (Total 15,000) * The dual-rate method permits a more refined allocation of the power department costs. It permits the use of different allocation bases for different cost pools. The Fixed cost result from decisions most likely associated with the scale of the facility,or the practical capacity level. The variable costs result from decision most likely associated with monthly usage. LO 2: How the uncertainty user managers face is affected by the choice between and actual cost-allocation rates? * Budgeted Budgeted rates let the user department know in advance the cost rates they will be charged. During the budget period, the supplier department, not the user departments, bears the risk of any unfavorable cost variances because the user departments do not pay for any costs that exceed the budgeted rates. When actual rates are used for cost allocation, managers do not know the rates to be used until the end of the budget period.

5 5 LO 3: Allocate support department costs using the direct, stepdown, and reciprocal methods. Direct method: Allocates support department costs to operating departments only. Step-down (sequential allocation) method: Allocates support department costs to other support departments and to operating departments. Note : Must begin allocating the support department that provide the highest proportion of services to the other support department. Reciprocal allocation method: Allocates costs by services provided among all support departments. EX 1 : *The Canton Division of Smith Corporation has : Two operating departments : (Assembly and Finishing) And two support departments Resources) KNOWING BELOW: Total square feet = 255,000 Maintenance is allocated using square feet. : (Maintenance and Human, Total number of employees = 95 Human Resources is allocated using number of employees.

6 6 1/ Direct Method : Maintenance Human Resources Budgeted costs Before allocations: $300,000 $2,160,000 Square feet: 5,000 30,000 Number of employees: 8 15 Assembly Finishing Budgeted costs Before allocations: $1,700,000 $900,000 Square feet: 110, ,000 Number of employees: Maintenance TO Assembly: $300,000 * (110,000/220,000) = 150,000 Maintenance TO Finishing : $300,000 * (110,000/220,000) = 150,000 * 110, ,000 = 220,000 Human Resources TO Assembly : 2,160,000*(48/72) = 1,440,000 Human Resources TO Finishing : 2,160,000*(24/72) = 900,000 * 48+24= 72 Assembly Finishing Original costs $1,700,000 $ 900,000 Maintenance Allocated: 150, ,000 Human Resources Allocated 1,440, ,000 Total $3,290,000 $1,770,000

7 7 2/ Step-Down Method: * Maintenance provides 12% of its services to Human Resources. *Human Resources provides 10% of its services to Maintenance. Must begin allocating the support department that provide the highest proportion of services to the other support department. Maintenance to Human Resources : 30,000 / 250,000 * 300,000 = 36,000 Maintenance to Assembly : * 30, , ,000 = 250, ,000 / 250,000 * 300,000 = 132,000 Maintenance to Finishing : 110,000 / 250,000 * 300,000 = 132,000 Costs before Allocated allocation costs Maintenance: $ 300,000 ($300,000) Human Resources: $2,160,000 $ 36,000 Assembly: $1,700,000 $132,000 Finishing: $ 900,000 $132,000 *Human Resources costs to be allocated become $2,160,000 + $36,000 = $2,196,000. Human Resources to Assembly: $2,196,000 = $1,464,000 Human Resources to Finishing: $2,196,000 = $732,000 Total cost after allocation: Assembly Department: Finishing Department: $1,700,000 + $132,000 + $1,464,000 = $3,296,000 $900,000 + $132,000 + $732,000 = $1,764,000

8 8 3/ Reciprocal Method: M HR A F Maintenance 12% 44% 44% Human Resources 10% 60% 30% *Maintenance cost = $300, P *Human Resource cost = $2,160, M M= 300, %(2,160,000+12%) M= 300, , M 10% * 2,160,000 = 216,000 10% * 12% = M 0.012M = (0.988 M / 0.988) = (516,000 / 0.988) M = 522,267 HR = 2,160, % (522,267) = 2,222,672 M HR A F Before allocation: $300,000 $2,160,000 $1,700,000 $ 900,000 Allocation: (522,267) 62, , ,797 Allocation: 222,267 ($2,222,672) 1,333, ,802 Total $3,263,400 $1,796,599 Total cost Assembly Department: $3,263,400 Total cost Finishing Department: $1,796,599 2,222,672 * 60% = 1,333,603 2,222,672 * 30% = 666,802 Comparison of Methods : Assembly Finishing Direct labor cost: $698,880 $349,440 Machine-hours: 24,000 23,500

9 9 Q : What are the various overhead rates using the three methods? 1/ Overhead Rates Direct Method : Assembly: $3,290,000 $698,880 direct labor costs = 471% of direct labor costs Finishing: $1,770,000 23,500 = $75.32 per machine-hour 2/ Overhead Rates Step-Down Method : Assembly: $3,296,000 $698,880 direct labor costs = 472% of direct labor cost Finishing: 1,770,000 23,500 = $75.32 per machine-hour 3/ Overhead Rates Reciprocal : Assembly: $3,263,400 $698,880 direct labor costs = 467% of direct labor cost Finishing: $1,796,599 23,500 = $76.45 per machine-hour * Comparison of Rates * Direct method: Finishing $75.32 Assembly 471% * Step-down method: $75.06 * Reciprocal method: $ % 467%

10 10 LO 4: Allocate common costs using either the stand-alone or incremental method. A common cost is a cost of operating a facility, activity, or like cost object that is shared by two or more users. Common costs exist because each user obtains a lower cost by sharing than the separate cost that would result if such a user were an independent entity. The goal is to allocate common costs to each user in a reasonable way. * Two methods for allocating common cost are: 1. Stand-alone cost allocation method The stand-alone cost-allocation method determines the weights for cost allocation by considering each user of the cost as a separate entity. Example: A consultant in Tampa is planning to go to Chicago and meet with an international client. The round-trip Tampa/Chicago/Tampa airfare costs $540. The consultant is also planning to attend a business meeting with a North Carolina client in Durham. The round-trip Tampa/Durham/Tampa airfare costs $360. The consultant decides to combine the two trips into a Tampa/Durham/Chicago/Tampa itinerary that will cost $760. How much should the consultant charge to the North Carolina client? $360 ($360 + $540) = $760 = $304 How much to the international client? $760 $304 = $456 * Advocates of this method often emphasize the fairness or equity criterion. The method is viewed as reasonable because each client bears a proportionate share of total costs in relation to the individual stand-alone costs.

11 11 2. Incremental cost allocation method The incremental cost-allocation method ranks the individual users of a cost object in the order of users most responsible for the common cost and then uses this ranking to allocate cost among those users. The first-ranked user of the cost object is the primary user (also called the primary party) and is allocated costs up to the costs of the primary user as a standalone user. The second-ranked user is the first-incremental user (first-incremental party) and is allocated the additional cost that arises from two users instead of only the primary user. The third-ranked user is the second-incremental user (second-incremental party) and is allocated the additional cost that arises from three users instead of two users, and so on. Example: (continued the example of Stand-Alone method) Assume that the business meeting in Chicago is viewed as the primary party. What would be the cost allocation? International client (primary) $540 = (the costs as a stand-alone) Durham client (incremental) $760 $540 = $220 LO 5: Explain the importance of explicit agreement between contracting parties when reimbursement is based on costs incurred. Contract disputes often arise with respect to cost allocation. Disputes can be reduced by making the cost-allocation rules as explicit as possible and in writing at the time the contract is signed. These rules should include details such as the allowable cost items, the acceptable cost-allocation bases, and how differences between budgeted and actual costs are to be accounted for.

12 12 LO 6: Understand how bundling of products gives rise to revenue-allocation issues. Allocation issues can also arise when revenues from multiple products (for example, different software programs or cable and internet packages) are bundled together and sold at a single price. The methods for revenue allocation parallel those described for common-cost allocations. A bundled product is a package of two or more products (or services) sold for a single price. Bundled product sales are also referred to as suite sales. Examples of business that provide bundled products are: Banks, Hotels and Tours. The individual components of the bundle also may be sold as separate items at their own stand-alone prices.

13 13 LO 7: Allocate the revenues of a bundled package to the individual products in that package. There are two main revenue allocation methods (as in the common-cost allocation): A. The Stand-Alone method The stand-alone revenue-allocation method uses product-specific information on the products in the bundle as weights for allocating the bundled revenues to the individual products. The term stand-alone refers to the product as a separate (nonsuite) item. There are four types of weights for the stand-alone revenue allocation method: 1. Selling prices This method uses the selling prices of the individual products to determine the weights for the revenue allocations. 2. Unit costs This method uses the costs of the individual products to determine the weights for the revenue allocations. 3. Physical units This method gives each product unit in the suite the same weight when allocating suite revenue to individual products. 4. Stand-alone product revenues This method captures the quantity of each product sold as well as their selling prices. Which method is preferred? The selling prices and stand-alone revenues methods are best, because the weights explicitly consider the prices customers are willing to pay for the individual products. Weighting approaches that use revenue information better capture benefits received by customers than unit costs or physical units. The physical-units revenue-allocation method is used when any of the other methods cannot be used (such as when selling prices are unstable or unit costs are difficult to calculate for individual products).

14 14 Example: English Languages Institute buys English language software programs locally and then sells them in Mexico and Central America. English sells the following programs: Grammar, Translation, and Composition These programs are offered stand-alone or in a bundle. If you are given that: Stand-alone Price Grammar $255 Translation $ 85 Composition $185 Purchasing these software programs costs English the following: Grammar $180 Translation $ 45 Composition $ 95 Bundle (Suites) Price Grammar + Translation $290 Grammar + Composition $350 Grammar + Translation + Composition $410 Consider the Grammar and Translation suite, which sells for $290 per day. How much weight should English Languages Institute assign to each item?

15 15 Answer: 1- using Selling prices: The individual selling prices are $255 for Grammar and $85 for Translation. Grammar: $255 $340 = 0.75, $ = $ Translation: $85 $340 = 0.25, $ = $ using Unit costs: Grammar: $180 $225 = 0.80, $ = $232 Translation: $45 $225 = 0.20, $ = $58 3- using Physical units: With two products in the suite, each product is allocated 50% of suite revenues. 1 (1 + 1) = 0.50 $ = $ using Stand-alone product revenues: Assume that the stand-alone revenues in 2003 are Grammar $734,400, Translation $81,600,and Composition $133,200. What are the weights for the Grammar and Translation suite? Grammar: $734,400 $816,000 = 0.90, $ = $261 Translation: $81,600 $816,000 = 0.10, $ = $29 Revenue Allocation Weights using the four methods: Grammar Translation Selling prices $ $ Unit costs Physical units Stand-alone product revenues

16 16 B. Incremental Revenue Allocation Method The incremental revenue-allocation method ranks individual products in a bundle according to criteria determined by management such as the product in the bundle with the most sales and then uses this ranking to allocate bundled revenues to individual products. The first-ranked product is the primary product in the bundle. The second ranked product is the first-incremental product, the third-ranked product is the second-incremental product, and so on. If the suite selling price exceeds the stand-alone price of the primary product, the primary product is allocated 100% of its stand-alone revenue. In other words, If the suite price is less than or equal to the stand-alone price of the primary product, the primary product is allocated 100% of the suite revenue. All other products in the suite receive no allocation of revenue. Example: (continued the example of Stand-Alone method) Assume that Grammar is designated as the primary product. And Grammar and Translation suite selling price $290 per day. Answer: Revenues Allocated to Grammar: $255 = (the selling price as a stand-alone) Remaining to be allocated: ($290 $255) = $35 Allocated to Translation: $35