Overview managerial accounting chapter 015

Allocate service department costs to other departments using the direct method.. Allocate service department costs to other departments using the step method.. Costs of a service departm

Chapter 15

Service Department Costing—An Activity Approach

Learning Objectives

LO1 Allocate service department costs to other departments using the direct method

LO2 Allocate service department costs to other departments using the step method

LO3 Allocate variable and fixed service department costs separately at the beginning of a

period and at the end of the period

New in this Edition

• New Business Focus boxes have been added

• The end-of-chapter materials have been expanded to include additional simple exercises

Chapter Overview

A Overview of Cost Allocation. Most large organizations have both operating and service departments

1 Operating departments Operating departments are those departments or units where the

central purposes of the organization are carried out Ordinarily, the operating departments are responsible for the major activities that ultimately generate revenue

2 Service departments Service departments provide services or assistance to the operating

departments Service departments engage in activities that do not generate significant revenue

3 Purpose of service department allocations Service department costs are allocated to

operating departments for a variety of reasons:

a To encourage managers of operating departments to make wise use of services provided by service departments

b To provide more complete cost data for making decisions in operating departments

c To help measure profitability in the operating departments

d To put pressure on the service departments to operate efficiently

e To develop overhead rates in the operating departments

B Allocation Bases. Costs of a service department are allocated to other departments using

an allocation base The allocation base should be whatever activity causes variations in the costs

of the service department; it should drive the service department’s costs Operating departments should be charged for whatever costs they cause—no more and no less

C Direct and Step Methods of Handling Reciprocal Services. Services provided by one service department to another are known as interdepartmental or reciprocal services The text discusses three approaches to handling the costs of interdepartmental services—the direct method, the step method, and the reciprocal method

1 The Direct Method (Exercises 15-1 and 15-6.) The direct method ignores

interdepartmental services Service department costs are directly allocated to operating departments—bypassing other service departments This method is slightly easier to use than the step method, but is less accurate

2 The Step Method (Exercises 15-2 and 15-5.) The step method takes some

interdepartmental services into account, but not all of them

a To use the step method, the service departments must be lined up in some sort of order The sequence typically begins with the department that provides the greatest amount of service to other departments and moves down through the service departments to the one that provides the least amount of service to the other departments In practice it isn’t always clear what the order should be, but in all of the illustrations in the text and

in all of the exercise and problem material, the order of allocation is given so that there

is no ambiguity

b The procedure followed in the step method is not inherently difficult, but it does contain some booby traps for unwary students Starting with the first service department in the sequence, allocate its costs out to all of the other departments— including all of the other service departments as well as all of the operating departments Ignore the first service department in all subsequent allocations Now move on to the second service department in order Add together its direct costs and all

of the service department costs that have been allocated to it Allocate these costs out to all of the remaining service departments (that is, all of the service departments except for itself and the first service department) and to all of the operating departments Continue like this to the bottom of the list of the service departments When the final service department is considered, there won’t be any service departments left to allocate costs to, so its costs (both direct and allocated from other service departments) will be allocated solely to the operating departments Working through an example in class is absolutely essential

3 The Reciprocal Method The direct method ignores interdepartmental services The step

method attempts to take into account the most important of the interdepartmental service relationships The reciprocal method takes into account all of the interdepartmental service relationships The reciprocal method doesn’t require any more information than the step method, but it uses more sophisticated mathematics (matrix algebra) to do the allocations Despite the elegance of this approach, it is rarely used The reasons for the lack of interest

in the reciprocal method are probably a lack of familiarity with the method, a general perception that it is a difficult and esoteric technique, and the likelihood that in most

situations the results from using the reciprocal method are not a lot different from the results obtained with the step method

D Cost Allocation Guidelines. (Exercises 15-3, 15-4, 15-7, 15-8, and 15-9.) Whenever possible, fixed and variable service department costs should be allocated separately This approach provides more useful data for planning and control of departmental operations as well

as to avoid inequities

1 Allocations of variable service department costs As a general rule, variable costs should

be charged to consuming departments on the basis of whatever activity causes the costs that are being allocated Budgeted, or predetermined, rates should be used There are two reasons for this First, it is difficult for departmental managers to decide how much service

to demand if they don’t know the rates until the end of the period Second, if actual rather than budgeted rates are used, the consumer of services is implicitly held responsible for how well the service department controlled its costs

2 Allocations at the beginning and end of the period The measure of activity that should

be used in assigning variable costs depends on whether the allocation is carried out at the beginning or at the end of the period

a If allocations are made at the beginning of the period, variable costs should be allocated

to departments at the budgeted rate based on the budgeted level of activity

Cost allocated at beginning of the period = Budgeted rate × Budgeted activity

b If allocations are made at the end of the period, variable costs should be allocated to departments at the budgeted rate based on the actual level of activity

Cost allocated at the end of the period = Budgeted rate × Actual activity

3 Allocations of fixed service department costs Generally speaking, the fixed costs of

service departments are incurred to provide capacity and the greater the capacity that is provided, the higher the fixed cost is likely to be Presumably, before deciding how much service department capacity to provide, managers are asked how much service they are going to need Based on these estimates, the capacity level of the service department is set and the required fixed costs are incurred In order to provide some check on how much service the managers say they are going to require, the operating departments should be charged for the portion of the capacity they claimed they would require This should be a lump-sum charge determined at the beginning of the period

E Behavioral Considerations. (Exercise 15-7.) Apart from the sound economics underlying lump-sum allocations of fixed costs, there is a strong behavioral reason to avoid allocating fixed costs the same way variable costs are allocated If fixed costs are allocated to departments are on the basis of some actual measure of activity such as actual sales or actual direct labor-hours, then the costs allocated to a given department will depend on what happens in other departments The activity in other departments will influence the denominator in the allocation rate If activity in other departments falls, the rate will go up and if their activity increases, the rate will go down These effects can generate quite a lot of heated (and counter-

Assignment Materials

Assignment Topic

Level of Difficulty

Suggested Time

Exercise 15-1 Direct method Basic 15 min Exercise 15-2 Step method Basic 15 min Exercise 15-3 Allocations by cost behavior at the beginning of the period Basic 10 min Exercise 15-4 Allocations by cost behavior at the end of the period Basic 15 min Exercise 15-5 Step method Basic 20 min Exercise 15-6 Direct method Basic 20 min Exercise 15-7 Sales dollars as an allocation base for fixed costs Basic 20 min Exercise 15-8 Allocating variable costs at the end of the year Basic 15 min Exercise 15-9 Allocations of fixed costs Basic 15 min Problem 15-10 Step method versus direct method; predetermined overhead

rates Basic 60 min Problem 15-11 Allocating by cost behavior Basic 45 min Problem 15-12 Allocating costs equitably among divisions Medium 30 min Problem 15-13 Step method Medium 45 min Problem 15-14 Beginning- and end-of-year allocations Medium 30 min Problem 15-15 Step method; predetermined overhead rates Medium 60 min Problem 15-16 Step method Medium 45 min Case 15-17 Direct method; plant wide versus departmental overhead

rates Difficult 90 min Case 15-18 Step method versus direct method Difficult 75 min

Essential Problems: Problem 15-10, Problem 15-11, Problem 15-12, Problem 15-14

Supplementary Problems: Problem 15-13, Problem 15-15, Problem 15-16, Case 15-17,

Case 15-18

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Chapter 15 Lecture Notes

Helpful Hint: The McGraw-Hill/Irwin Managerial/Cost Accounting video library does not contain any segments related to chapter 15

Chapter theme: Most large organizations have both

operating departments and service departments The

central purposes of the organization are carried out in the operating departments In contrast, service departments do not directly engage in operating activities This chapter

discusses why and how service department costs are

allocated to operating departments

Helpful Hint: Ask students if they ever worked in a large organization where the charges of service departments seemed exorbitant Then ask students why this happens Often the reason is that internal work charges include arbitrary allocations of fixed general administrative overhead and an allowance for the fixed costs of the service department itself This creates a spiraling effect Since the charges are so high, demand falls and the rates are pushed even higher

I Why allocate service department costs?

A Six reasons for allocating service department costs

i To encourage operating departments to wisely

use service department resources

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ii To provide operating departments with more

complete cost data for making decisions

iii To help measure the profitability of

operating departments

iv To create an incentive for service

departments to operate efficiently

v To value inventory for external financial

reporting purposes

vi To include all overhead in the cost base when

cost-plus pricing is used

II Allocations using the direct and step methods

A Selecting allocation bases

i The allocation bases used should “drive” the

cost being allocated For example:

1 When allocating the costs of the employee

cafeteria, the number of meals served

would be a good choice for the allocation base

ii A given service department’s costs may be

allocated using more than one base For

example:

1 The costs of a human resources department might be divided into two parts, with one part

allocated based on the number of employees

in each department and the other part

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allocated on the basis of hours spent in training

programs run by the human resources

department

iii Other examples of allocation bases that are

commonly used by service departments are as shown

“In Business Insights”

Activity-based costing can be used to improve the accuracy of service department allocation For example:

“Increasing Accuracy at Hughes Aircraft” (page 719)

• For many years, Hughes Aircraft allocated

service department costs to operating departments using headcount as the allocation base

• This method, while simple, was inaccurate

because most service department costs were not driven by the number of employees in the

operating departments

• To overcome this problem, the company

implemented activity-based costing For example, the costs of the Human Resources Department are now allocated on the basis of headcount, new hires, union employees, and training hours in each operating department

• Operating managers can control the amount of

Human Resources cost allocated to them by controlling the quantity of the aforementioned allocation bases consumed

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interdepartmental or reciprocal services

2 Three approaches are used to allocate the

costs of service departments to other

departments – these are known as the direct

method, the step method, and the reciprocal method

ii Direct method: a definition

1 The direct method is the simplest of the

three cost allocation methods because it

ignores the services provided by a service

department to other service departments It

allocates all costs directly to operating

departments

“In Business Insights”

The direct method of service department allocation is commonly used in practice For example:

“A Losing Football Program” (page 720)

• At Georgia Tech, service department costs are

allocated to intercollegiate sports programs using the direct method

• For example, the costs of the Sports Medicine

Department are allocated on the basis on the number of student athletes in each intercollegiate sport

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• Other service departments include Facilities,

Sports Information, Academic Center, Athletes Program, Office Supplies, Legal and Audit, Accounting Office, Marketing, and Administrative

Student-• Georgia Tech’s football program shows a margin

of over $1 million based on its own direct costs, but a loss of over $800,000 when service

department costs are allocated to the program

iii Direct method: an example

1 Assume that a company has two service

departments (Cafeteria and Custodial) and two operating departments (Machining and

Assembly) with accompanying information

as shown

2 How much of the Cafeteria and Custodial

costs should be allocated to each operating department?

3 The Machining Department would be allocated $144,000 of the Cafeteria

Department’s costs as shown Notice:

a The allocation base is the number of

Department’s costs as shown Notice:

a The sum of the costs assigned to

Assembly ($216,000) and Machining ($144,000) is equal to the total costs

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assigned from the Cafeteria

($360,000)

5 The Machining Department would be allocated $30,000 of the Custodial

Department’s costs as shown Notice:

a The allocation base is square feet

occupied

6 The Assembly Department would be allocated $60,000 of the Custodial

Department’s costs as shown Notice:

a The sum of the costs assigned to

Assembly ($60,000) and Machining ($30,000) is equal to the total costs

assigned from the Custodial

Department ($90,000)

Helpful Hint: What to include in the allocation base under the direct method often confuses students For example, if personnel department costs are allocated on headcount, should the Personnel Department

headcount and that of other service departments be included? While it doesn’t seem to make much sense economically, the service departments must be excluded

to avoid allocating costs back to the service departments

iv Step method: a definition

1 The step method provides for allocation of a

service department’s costs to other service

departments, as well as to operating

departments It is sequential and the

sequence usually begins with the department

that provides the greatest amount of

service to other service departments

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a Once a service department’s costs have been allocated to other departments,

other service department costs are not

allocated back to it

2 There are three key points to understand

regarding the step method:

a 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

b Any amount of the allocation base that

is attributable to a service department

whose cost has already been allocated is ignored

c Each service department assigns its

own costs to operating departments

plus the costs that have been

allocated to it from other service

departments

“In Business Insights”

The step method of allocating service department costs

is also commonly used in practice For example:

“Stepping Down at Group Health” (page 722)

• Group Health Cooperative of Puget Sound is a

large health maintenance organization with 500 service departments that account for 30% of Group Health’s total costs

• The step method is used to allocate these costs to

patient care departments and then to patients

• These allocations are done so that costs can be

summarized in a variety of ways including “by consumers, by diagnostic groupings, by employer

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groups, and by specific populations, such as Medicare, Medicaid, AIDS, Heart Care, and so on.”

v Step method: an example

1 Assume the same facts that were used for

the direct method example

2 How much of the Cafeteria and Custodial

costs should be allocated to each operating department?

a Assume that the Cafeteria costs are

allocated first followed by the

Custodial Department

3 The Custodial Department would be allocated $60,000 of the Cafeteria

Department’s costs as shown Notice:

a The allocation base is the number of

employees, and the quantity of

employees in the denominator is 60

4 The Machining Department would be allocated $120,000 of the Cafeteria

Department’s costs as shown

5 The Assembly Department would be allocated $180,000 of the Cafeteria

Department’s costs as shown Notice:

a The sum of the assigned costs

($60,000 + $120,000 + $180,000)

equals the total Cafeteria Department

costs of $360,000

6 The Custodial Department will allocate

$150,000 in total costs This amount

includes the department’s own costs of

$90,000 plus the amount allocated from the

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7 The Machining Department would be allocated $50,000 of the Custodial

Department’s costs as shown Notice:

a The allocation base is square feet

occupied

8 The Assembly Department would be allocated $100,000 of the Custodial

Department’s costs as shown Notice:

a The sum of the costs assigned to

Assembly ($100,000) and Machining ($50,000) is equal to the total costs

assigned from the Custodial

Department ($150,000)

Helpful Hint: What to include in the allocation base under the step method often confuses students Never include in the allocation base the service department whose cost is being allocated; once a service

department’s cost has been allocated, pretend the department does not exist anymore In other words, at each step allocate a service department’s costs to the remaining service departments and to all of the

operating departments

vi Reciprocal method: a definition

1 The reciprocal method gives full

recognition to interdepartmental services

While the step method only allocates costs forward – never backwards – the reciprocal

method allocates costs in both directions

2 Reciprocal allocation requires the use of

simultaneous linear equations and is

beyond the scope our book

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3 The reciprocal method is rarely used in

practice because of its complexity and

because of the fact that the results usually

are close to those provided by the step

method

Helpful Hint: Students may object to the inaccuracies of the step method This gives an opportunity to explain the reciprocal method Ask students what would happen

if every service department’s costs were allocated to all

of the service departments (including itself as appropriate) Someone should answer that some costs would still be left in the service departments when the allocations are finished Ask what would happen if you started over and used the same procedure to allocate the service department costs that remain Someone should answer that some costs would still be left in the service departments, but the costs would be less than before In fact, if this process is repeated many times until no costs are left in the service departments, you have essentially performed a reciprocal allocation

vii If a service department generates revenue,

such as a cafeteria that charges for the service that it provides, the revenue generated should

be offset against the costs incurred Only the remaining net amount of costs should be

allocated to other departments

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Quick Check – direct and step methods

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