1. © 2012 McGraw-Hill Education (Asia) Cost Allocation Chapter 6

2. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 2 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

3. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 3 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

4. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 4 Learning Objective 1 Explain the major reasons for the need for allocating nonmanufacturing costs.

5. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 5 Service Department Charges Operating Departments Carry out central purposes of organization. Service Departments Do not directly engage in operating activities.

6. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 6 Reasons for Charging Service Department Costs 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. Service department costs are charged to operating departments for a variety of reasons including:

7. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 7 Management Needs  Need to understand the full cost of providing a product or service (including supporting costs) to make better decision. 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

8. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 8 $ Transfer Prices Operating Departments Service Departments 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.

9. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 9 Factors To Be Considered For 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

10. © 2012 McGraw-Hill Education (Asia) Service Department Charges

11. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 11 Learning Objective 2 Allocate costs of service departments to other operating departments/units using the cost behavior concept.

12. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 12 Charging Costs by Behavior Whenever possible, variable and fixed service department costs should be charged separately.

13. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 13 Variable service department costs should be charged to consuming departments according to whatever activity causes the incurrence of the cost. Charging Costs by Behavior

14. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 14 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 of capacity each consuming department requires. Should not vary from period to period. Charging Costs by Behavior

15. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 15 Should Actual or Budgeted Costs Be Charged? Budgeted variable and fixed service department costs should be charged to operating departments.

16. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 16 Sipco has a maintenance department and two operating departments: Cutting and Assembly. Variable maintenance costs are budgeted at $0.60 per machine hour. Fixed maintenance costs are budgeted at $200,000 per year. Data relating to the current year are: Allocate maintenance costs to the two operating departments. Sipco: An Example

17. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 17 Actual hours Sipco: End of the Year

18. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 18 Percent of peak-period capacity. Sipco: End of the Year Actual hours

19. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 19 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:

20. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 20 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 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

21. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 21 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 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 Quick Check

22. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 22 Allocating fixed costs using a variable allocation base. Pitfalls in Allocating Fixed Costs Result Fixed costs allocated to one department are heavily influenced by what happens in other departments.

23. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 23 Using sales dollars as an allocation base. Pitfalls in Allocating Fixed Costs Result Sales of one department influence the service department costs allocated to other departments.

24. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 24 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 the service department costs based on sales.

25. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 25 Autos R Us – First-year Allocation $1,500,000 ÷ $3,000,000 50% of $80,000 In the next year, the manager of the New Cars department increases sales by $500,000. Sales in the other departments are unchanged. Let’s allocate the $80,000 service department cost for the second year given the sales increase.

26. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 26 Autos R Us – Second-year Allocation $2,000,000 ÷ $3,500,000 57% of $80,000 If you were the manager of the New Cars department, would you be happy with the increased service department costs allocated to your department?

27. © 2012 McGraw-Hill Education (Asia) Service Department Allocations

28. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 28 Operating Departments An operating department carries out the central purpose of the organization The Surgery Department at Mount Sinai Hospital. A Production Department at Mitsubishi. The Geography Department at the University of Washington.

29. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 29 Service Departments Service departments do not directly engage in operating activities. The Accounting Department at Macy’s. The Human Resources Department at Walgreens.

30. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 30 Interdepartmental Services Service Department Operating Department Costs of the service department become overhead costs to the operating department

31. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 31 Allocation Approaches

32. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 32 Reciprocal Services Service Department 1 Service Department 2 When service departments provide services to each other we call them reciprocal services.

33. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 33 Learning Objective 3 Allocate service department costs to operating departments using the direct method.

34. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 34 Direct Method Service Department (Cafeteria) Service Department (Custodial) Operating Department (Machining) Operating Department (Assembly) Interactions between service departments are ignored and all costs are allocated directly to operating departments. Interactions between service departments are ignored and all costs are allocated directly to operating departments.

35. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 35 Direct Method – An Example

36. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 36 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?

37. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 37 Direct Method – An Example Allocation base: Number of employees

38. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 38 Direct Method – An Example Allocation base: Number of employees $360,000 × 30 20 + 30 = $216,000

39. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 39 Direct Method – An Example Allocation base: Square feet occupied $90,000 × 25,000 25,000 + 50,000 = $30,000

40. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 40 Direct Method – An Example Allocation base: Square feet occupied 50,000 25,000 + 50,000 $90,000 × = $60,000

41. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 41 Learning Objective 4 To allocate service department costs to operating departments using the step-down method.

42. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 42 Operating Department (Machining) Operating Department (Assembly) Step-Down Method Once a service department’s costs are allocated, other service department costs are not allocated back to it. Service Department (Cafeteria) Service Department (Custodial)

43. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 43 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. Step-Down Method

44. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 44 We will use the same data used in the direct method example. Step-Down Method – An Example

45. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 45 Allocate Cafeteria costs first since it provides more service than Custodial. Step-Down Method – An Example

46. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 46 $360,000 × 10 10 + 20 + 30 = $60,000 Allocation base: Number of employees Step-Down Method – An Example

47. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 47 $360,000 × 20 10 + 20 + 30 = $120,000 Allocation base: Number of employees Step-Down Method – An Example

48. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 48 $360,000 × 30 10 + 20 + 30 = $180,000 Allocation base: Number of employees Step-Down Method – An Example

49. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 49 New total = $90,000 original Custodial cost plus $60,000 allocated from the Cafeteria. Step-Down Method – An Example

50. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 50 $150,000 × 25,000 25,000 + 50,000 = $50,000 Allocation base: Square feet occupied Step-Down Method – An Example

51. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 51 $150,000 × 50,000 25,000 + 50,000 = $100,000 Allocation base: Square feet occupied Step-Down Method – An Example

52. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 52 Reciprocal Method Interdepartmental services are given full recognition rather than partial recognition as with the step method. Service Department (Cafeteria) Service Department (Custodial) Operating Department (Machining) Operating Department (Assembly) Because of its mathematical complexity, the reciprocal method is rarely used.

53. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 53 Quick Check Data for Direct and Step-Down Methods Allocation bases: Business school administration costs (ADMIN): Number of employees Business Administration computer services (BACS): Number of personal computers The direct method of allocation is used.

54. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 54 Quick Check How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000

55. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 55 How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000 Quick Check $180,000 × 20 20 + 80 = $36,000

56. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 56 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

57. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 57 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

58. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 58 Quick Check Data Allocation bases: Business school administration costs (ADMIN): Number of employees Business administration computer services (BACS): Number of personal computers Allocation bases: Business school administration costs (ADMIN): Number of employees Business administration computer services (BACS): Number of personal computers The step method of allocation is used.

59. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 59 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

60. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 60 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 Check

61. McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen McGraw-Hill/Irwin Slide 61 End of Chapter 6