Support Department Cost Allocation CHAPTER

After studying this chapter, you should be able to: Objectives 1. Describe the difference between support departments and producing departments. 2. Calculate single and multiple changing rates for a support department. 3. Allocate support-department costs to producing departments using the direct, sequential, and reciprocal methods. 4. Calculate departmental overhead rates. After studying this chapter, you should be able to:

Types of Departments Producing departments are directly responsible for creating the products or services sold to customers.

Maintenance, grounds, engineering, personnel, storage Types of Departments Supporting departments provide essential support services for producing departments. Maintenance, grounds, engineering, personnel, storage

Steps in Allocating Support Department Costs to Producing Departments 1. Departmentalize the firm. 2. Classify each department as a support department or a producing department. 3. Trace all overhead costs in the firm to a support department or producing department. 4. Allocate supports department costs to the producing departments. Continued

Steps in Allocating Support Department Costs to Producing Departments 5. Calculate predetermined overhead rates for the producing departments. 6. Allocate overhead costs to the units of individual products through the predetermined overhead rates.

Examples of Cost Drivers for Support Departments Support Department Possible Driver Accounting Number of transactions Cafeteria Number of employees Engineering Number of change orders Maintenance Machine hours; maintenance hours Payroll Number of employees Personnel Number of employees, firings, layoffs, new hires

Objectives of Allocation 1. To obtain a mutually agreeable price. 2. To compute product-line profitability. 3. To predict the economic effects of planning and control. 4. To value inventory. 5. To motivate managers.

Note Objective 5: Allocations can be used to motivate managers.

Hamilton Barry Fixed costs……………… $26,190 AND Barry Hamilton Fixed costs……………… $26,190 Variable costs….. $0.023 per page

A Single Charge Rate Hamilton Barry Estimated usage (in pages) by the three producing departments is as follows: Audit Department 94,500 Tax Department 67,500 MAS Department 108,000 Total 270,000 Variable cost: 270,000 x $0.023 $ 6,210 Fixed cost 26,190 Total cost for 270,000 pages $32,400 Barry Hamilton Average cost ($32,400 ÷ 270,000) $0.12 per page

Total Photocopying Department Charge A Single Charge Rate Total Photocopying Department Charge Number of Pages Charge per Page Total Charges x = Audit Department 92,000 $0.12 $11,040 Tax Department 65,000 0.12 7,800 MAS Department 115,000 0.12 13,800 Total 272,000 $32,640

Multiple Charging Rates Amount Allocated to Each Department Peak Number of Pages Proportion of Peak Usage Total Fixed Costs Audit 7,875 0.20 $26,190 $ 5,238 Tax 22,500 0.57 26,190 14,928 MAS 9,000 0.23 26,190 6,024 Total 39,375 $26,190

Multiple Charging Rates Number of Pages x $0.023 Fixed Cost Allocation Total Charges + = Audit department $2,116 $ 5,238 $ 7,354 Tax department 1,495 14,928 16,423 MAS department 2,645 6,024 8,669 Total $6,256 $26,190 $32,446

Budgeted Versus Actual Usage When we allocate support-department costs to the producing departments, should we allocate actual or budgeted costs?

Budgeted Versus Actual Usage Budgeted costs.

Budgeted Versus Actual Usage A general principle of performance evaluation is that managers should not be held responsible for costs or activities over which they have no control.

Use of Budgeted Data for Product Costing Number of Copies Total Rate Allocated Charges x = Audit Department 94,500 $0.12 $11,340 Tax Department 67,500 0.12 8,100 MAS Department 108,000 0.12 12,960 Total 270,000 $32,400

Use of Actual Data for Performance Evaluation Purposes Number of Copies Total Rate Allocated Charges x = Audit department 92,000 $0.12 $11,040 Tax department 65,000 0.12 7,800 MAS department 115,000 0.12 13,800 Total 272,000 $32,640

Choosing A Service Department Cost Allocation Method The three methods for allocating service department costs to producing departments are: The Direct Method The Sequential Method The Reciprocal Method

Data for Illustrating Allocation Methods Support Departments Producing Departments Direct costs* $250,000 $160,000 $100,000 $ 60,000 Normal activity: Kilowatt-hours ----- 200,000 600,000 200,000 Maintenance hours 1,000 ----- 4,500 4,500 *For a producing department, direct costs refer only to overhead costs that are directly traceable to the department. Power Maintenance Grinding Assembly

Direct Method of Allocation Power Maintenance Grinding Assembly

Direct Method of Allocation Power Maintenance Grinding Assembly

STEP 1—CALCULATE ALLOCATION RATIOS Grinding Assembly Power = 600,000 (600,000 + 200,000) 0.75 200,000 (600,000 + 200,000) 0.25 Maintenance = 4,500 (4,500 + 4,500) 0.50 4,500 (4,500 + 4,500) 0.50 Direct Method

STEP 2—ALLOCATE SUPPORTS DEPARTMENT COSTS USING THE ALLOCATION RATIOS Support Departments Producing Departments Power Maintenance Grading Assembly Direct costs $250,000 $160,000 $100,000 $ 60,000 Power -250,000 --- 187,500 62,500 Maintenance --- -160,000 80,000 80,000 $ 0 $ 0 $367,500 $202,500 a b a 0.75 x $250,000 = $187,500; 0.25 x $250,000 = $62,500 0.50 x $160,000 = $80,000 b Direct Method

STEP 1: Rank service departments Sequential Method of Allocation STEP 1: Rank service departments Power 1 Maintenance 2

Sequential Method of Allocation STEP 2 Power Maintenance Grinding Assembly

Sequential Method of Allocation STEP 2 Maintenance Grinding Assembly

STEP 1—CALCULATE ALLOCATION RATIOS Maint. Grinding Assembly Power = 200,000 (200,000 + 600,000 + 200,000) 0.20 600,000 (200,000 + 600,000 + 200,000) 0.60 Sequential Method

STEP 1—CALCULATE ALLOCATION RATIOS Maint. Grinding Assembly Mainte- nance 4,500 (4,500 + 4,500) 0.50 = 4,500 (4,500 + 4,500) 0.50 Sequential Method

STEP 2—ALLOCATE SUPPORT DEPARTMENT COSTS USING THE ALLOCATION RATIOS Support Departments Producing Departments Power Maintenance Grading Assembly Direct costs $250,000 $160,000 $100,000 $ 60,000 Power -250,000 50,000 150,000 50,000 Maintenance --- -210,000 105,000 105,000 $ 0 $ 0 $355,000 $215,000 a b a 0.20 x $250,000 = $50,000; 0.60 x $250,000 = $150,000; 0.20 x $250,000 = $50,000 0.50 x $210,000 = $105,000 b Sequential Method

Reciprocal Method The reciprocal method of allocation recognizes all interactions among support departments.

Reciprocal Method Support Departments Producing Departments Power Maintenance Grading Assembly Direct costs: Normal activity: Kilowatt-hours --- 200,000 600,000 200,000 Maintenance hours 1,000 --- 4,500 4,500 Proportion of Output Used by Departments Power Maintenance Grading Assembly Allocated ratios: Power --- 0.20 0.60 0.20 Maintenance 0.10 --- 0.45 0.45

Reciprocal Method M = Direct costs + Share of Power’s costs M = $160,000 + $50,000 + 0.02M 0.98M = $210,000 M = $214,286

Reciprocal Method P = Direct cost + Share of Maintenance’s cost = $250,000 + 0.1($214,286) P = $250,000 + $21,429 P = $271,429 P

ALLOCATE SUPPORT DEPARTMENT COSTS USING THE ALLOCATION RATIOS AND THE SUPPORT-DEPARTMENT COSTS FROM RECIPROCAL METHODS EQUATIONS Support Departments Producing Departments Power Maintenance Grading Assembly Direct costs $250,000 $160,000 $100,000 $ 60,000 Power -271,429 54,286 162,857 54,286 Maintenance 271,429 -214,286 96,429 96,429 Total $ 0 $ 0 $359,286 $210,715 from Slide 7-35 from Slide 7-34

Comparison of Support Department Cost Allocations Using the Direct, Sequential, and Reciprocal Methods Direct Method Grinding Assembly Direct costs $100,000 $ 60,000 Allocated from power 187,500 62,500 Allocated from maintenance 80,000 80,000 Total cost $367,500 $202,500 Click on button to compare with sequential method Return to show Click on button to compare with reciprocal method

Comparison of Support Department Cost Allocations Using the Direct, Sequential, and Reciprocal Methods Sequential Method Grinding Assembly Direct costs $100,000 $ 60,000 Allocated from power 150,000 50,000 Allocated from maintenance 105,000 105,000 Total cost $355,000 $215,000 Click on button to compare with direct method Return to show Click on button to compare with reciprocal method

Comparison of Support Department Cost Allocations Using the Direct, Sequential, and Reciprocal Methods Reciprocal Method Grinding Assembly Direct costs $100,000 $ 60,000 Allocated from power 162,857 54,286 Allocated from maintenance 96,429 96,429 Total cost $359,286 $210,715 Click on button to compare with direct method Return to show Click on button to compare with sequential method

Departmental Overhead Rates The overhead rate for the grinding department is computed as follows (assuming the normal level of activity is 71,000 MH): OH rate = $355,000  71,000 = $5 per MH The overhead rate for the assembly department is computed as follows (assuming the normal level of activity is 107,500 DLH): OH rate = $215,000  107,500 = $2 per DLH

Product Unit Cost A product requires two machine hours of grinding per unit and one hour of assembly. Overhead cost assigned: 2 x $5 $10 1 x $2 2 Total assigned $12

Chapter Seven The End