Cost Accounting Instructor's Manual (15)

Allocation of Support-Department Costs,

15

Common Costs, and Revenues

TRANSITION NOTES

This chapter includes a rewritten section dealing with budgeted versus actual usage with

expanded material on allocation bases. There is expanded material explaining the use of

budgeted rates for allocating support department costs. The section on allocating common

costs has been streamlined. Most end- of-chapter problem material is new or has been

revised.

PROBLEM MATERIAL

CORRELATION CHART

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I.

LEARNING OBJECTIVES

1.

2.

3.

4.

5.

6.

Distinguish between the single-rate method from the dual-rate method.

Understand how divisional incentives are affected by the choice between

allocation based on budgeted and actual rates and budgeted and actual usage.

Allocate multiple support-department costs using the direct method, the step-

down method, and the reciprocal method.

Allocate common costs using the stand-alone method and the incremental

method.

Explain the importance of explicit agreement between contracting parties when

the reimbursement amount is based on costs incurred.

Understand how bundling of products gives rise to revenue-allocation issues and

the methods for doing so.

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II.

CHAPTER SYNOPSIS

Allocation of indirect costs is an area of constant discussion in many companies, with

division, department, and product managers often questioning the amount of indirect

costs allocated to their respective sections. This chapter discusses allocation of support

department costs using the direct method, the step-down method, and the reciprocal

method. The chapter presents the stand-alone method and the incremental method as

techniques for allocation of common costs. The concept of bundled products and

allocation of bundled product revenues is also introduced. Cost reimbursement based on

contract provisions is also discussed.

III.

POINTS OF EMPHASIS

1.

It is important that the students grasp allocation issues including single- versus

dual- rate allocation before moving into the methods for allocating costs to the

service departments.

Likewise, students need to see the varying effects of actual versus budgeted cost

allocations.

Work through each of the methods for allocating costs with multiple support

departments

—

direct, step-down, and reciprocal. Illustrate the differences

obtained under each method. If the differences are small, point out that the

simplest method would work best in the particular case.

Allocating common costs and allocating revenues of bundled products are really

two sides of the same process. If the students grasp allocating common costs

early, allocating bundled revenues should be fairly simple.

2.

3.

4.

IV.

CHAPTER OUTLINE

LEARNING

OBJECTIVE

1

Distinguish the single-rate method

…

one rate for allocating costs in a cost pool

from the dual-rate method

…

two rates for allocating costs in a cost pool

—

one

for variable costs and one for fixed costs

1.1

Companies distinguish operating departments from support departments. An

operating department,

which is also called a

production department,

is one

that directly adds value to the product or service. A

support department,

which

is also called a

service department,

provides support and assists operating

departments and other service departments.

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TEACHING

POINT.

If

students

do

not

grasp

the

difference

in

operating departments and support departments early, they will

not

learn

the

material

in

this

chapter.

Identify

several

departments

that

might

be

found

in

a

typical

manufacturing

organization, and have the students identify them as operating

or support departments.

1.2

Costs incurred in the support departments must be allocated ultimately to the

operating departments and eventually to the final cost object. A predetermined

rate is normally utilized to make the allocations to the operating departments. A

single-rate

or a

dual-rate method

may be utilized.

The

single-rate method

makes no distinction between fixed and variable costs. It

allocates costs in each cost pool to cost objects using the same rate per unit of a

single allocation base.

The

dual- rate method

divides the costs of each support department into two

pools

—

a variable- cost pool and a fixed-cost pool.

When using either the single-rate or dual-rate method, managers may allocate

costs based upon:

?

?

?

Budgeted rates and budgeted hours.

Budgeted rates and actual hours.

Actual rates and actual hours

—

this approach is not often used in practice.

TEACHING

POINT.

It

will

be

helpful

if

the

students

can

visualize

these

concepts

in

action.

Exercise

15-16

is

a

good

illustration of different approaches to allocation.

1.3

1.4

1.5

Refer to Quiz Question 1

Exercise 15-16 and 15-17

LEARNING

OBJECTIVE

2

Understand how divisional incentives are affected by the

choice between allocation based on budgeted and

actual rates,

…

budgeted rates provide certainty to users about

charges and motivate the support division to engage in

cost control

and budgeted and actual usage

…

budgeted usage helps in planning and efficient

utilization of fixed resources, actual usage controls

consumption of variable resources

2.1

Once the decision has been made regarding single- or dual- rate allocation, the

manager must next turn to the issue of choosing between allocating budgeted or

actual costs.

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2.2

2.3

When allocations are based on

budgeted usage

user divisions know in advance

their allocated costs. This can be of benefit in short- term and long-term planning.

A disadvantage of using budgeted costs is that there is an incentive for managers

to underestimate their planned usage, thus being assigned a lower percentage of

allocated costs. This can be overcome in part by assessing a higher charge for

exceeding budgeted usage.

Allocating costs based on

actual usage

gives a more accurate allocation based on

actual costs and usage.

Actual allocations have several disadvantages: a lack of timely information,

reduced incentives for support to manage costs, and increased accounting costs.

A third approach is to allocate fixed costs on the basis of

practical capacity

supplied. This approach will charge each division with services actually used. In

addition, variations in actual usage in one division will not affect allocations in

other divisions. Finally, the costs of unused capacity are highlighted and not

allocated to divisions.

TEACHING POINT. Th

is is an excellent time to discuss “game

playing” with students to show how a department manager can

lower

the

amount

being

allocated

to

the

department

by

low-

balling

estimated

usage

(when

budgeted

capacity

is

used).

Likewise, you can illustrate the lack of incentive on the part of

supplying departments to control costs if actual costs are used

for

allocation.

Enter

into

a

discussion

of

how

the

problems

presented by these two approaches might be resolved.

2.4

2.5

2.6

2.7

Generally, it is found to be preferable to allocate fixed costs based on capacity,

under the approach that fixed costs provide capacity and variable costs allocated

based on actual usage.

(Exhibit 15-1 displays the impact of variations in actual usage

on division cost allocations.)

Refer to Quiz Question 2

Exercise 15-18 and Problem 15-27

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LEARNING

OBJECTIVE

3

Allocate support-department costs using the direct

method,

…

allocate support-department costs directly to

operating departments

the step-down method,

…

partially allocates support-department costs to

other support departments

and the reciprocal method

…

fully allocates support- department costs to other

support departments

3.1

When allocating costs from multiple support departments, a new set of problems

arise. These problems arise because support departments utilize the services of

other support departments and it must be decided how to handle these allocations.

There are three approaches that may be utilized.

?

The

direct method

allocates support department costs to operating

departments only, ignoring usage of a support department by other

support departments.

The

step-down method

or

sequential allocation method

allocates

support-department costs to other support departments and to operating

departments in a sequential manner that partially recognizes the mutual

services provided among all support departments.

o

A common step-down sequence begins with the support

department that renders the highest percentage of its total

services to other support departments. Another approach is to

begin with the department providing the highest dollar amount to

other support departments.

Once costs are allocated out of a support department under the

step-down method, no additional costs are allocated to that

department.

?

o

?

The

reciprocal method

fully recognizes the mutual services provided

among all support departments. These allocations can be performed by

using repeated iterations of allocations or by formulating and solving

linear equations expressing the relationships among the departments.

o

There are three steps involved in the reciprocal method.

Step 1:

Step 2:

Express support department costs and reciprocal

relationships in the form of linear equations.

Solve the set of linear equations to obtain the

complete reciprocated costs of each support

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department.

Step 3:

Allocate the complete reciprocated costs of each

support department to all other departments based on

the usage percentages.

TEACHING

POINT.

Work

through

exercises,

such

as

15-19

and

15-20,

that

illustrate

each

of

these

approaches.

Do

the

step-down

method

using

one

approach,

and

then

have

the

students

do

it

using

the

other

approach.

Discuss

the

differences obtained using the various methods.

3.2

The direct and step-down methods have the advantage of simplicity. The

reciprocal method is theoretically the most precise, but is difficult to implement,

especially with a large number of support departments. However, this difficulty

is being lessened by the use of computers. In determining which method to utilize,

the company should consider the amount of differences obtained under each of

the approaches.

(Exhibits 15-2 to 15-6 illustrate allocation of support department costs.)

Refer to Quiz Questions 3, 4, and 5

Exercises 15-19,

15-20, 15-21, and 15-22

LEARNING

OBJECTIVE

4

Allocate common costs using the stand-alone

method

…

uses cost information of each user as a

separate entity to allocate common costs

and the incremental method

…

allocates common costs primarily to one user

and the remainder to other users

4.1

4.2

Common costs

are costs that are shared by two or more users. These can be the

costs of operating a facility, an activity, or other cost objects.

These common costs must be allocated in some equitable fashion. Two methods

that are frequently used for these allocations are the

stand-alone cost-allocation

method

and the

incremental cost-allocation method.

TEACHING POINT. Brainstorm with the students for examples

of common costs. For example, software that students buy for

college is a common cost for all classes in which they use the

computer. To get into the allocation issue, tell them they must

purchase

Excel

for

use

in

the

Cost

Accounting

class.

After

purchasing

it,

however,

they

find

use

for

it

in

three

other

classes. If they are trying to determine the cost of each class,

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