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 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 Service departments Service departments provide services or assistance to the operating departments Service departments engage in activities that not generate significant revenue 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 f To help determine the cost base in cost-plus pricing 1026 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 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 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 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 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 1027 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 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 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 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 counterproductive) arguments among managers 1028 Assignment Materials Assignment Exercise 15-1 Exercise 15-2 Exercise 15-3 Exercise 15-4 Exercise 15-5 Exercise 15-6 Exercise 15-7 Exercise 15-8 Exercise 15-9 Problem 15-10 Problem 15-11 Problem 15-12 Problem 15-13 Problem 15-14 Problem 15-15 Problem 15-16 Case 15-17 Case 15-18 Topic Direct method Step method Allocations by cost behavior at the beginning of the period Allocations by cost behavior at the end of the period Step method Direct method Sales dollars as an allocation base for fixed costs Allocating variable costs at the end of the year Allocations of fixed costs Step method versus direct method; predetermined overhead rates Allocating by cost behavior Allocating costs equitably among divisions Step method Beginning- and end-of-year allocations Step method; predetermined overhead rates Step method Direct method; plant wide versus departmental overhead rates Step method versus direct method Level of Difficulty Basic Basic Basic Basic Basic Basic Basic Basic Basic Suggested Time 15 15 10 15 20 20 20 15 15 Basic Basic Medium Medium Medium Medium Medium 60 45 30 45 30 60 45 Difficult Difficult 90 75 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 1029 1030 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 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 1031 1032 II 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 Allocations using the direct and step methods A Selecting allocation bases i When allocating the costs of the employee cafeteria, the number of meals served would be a good choice for the allocation base ii The allocation bases used should “drive” the cost being allocated For example: A given service department’s costs may be allocated using more than one base For example: 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 1033 1034 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 1035 B Beware of sales dollars as an allocation base i 60 While sales dollars is a popular allocation base for service department costs, it is a poor choice because sales dollars fluctuate from period to period, whereas the costs being allocated are often largely fixed This creates a situation where the sales in one department will influence the service department costs allocated to another department ii 61 62 63 Clothier Inc – an example Assume the facts as shown with respect to Clothier Inc The allocations of service department costs for year one are as shown Notice: a The Suits Department generated 65% of total sales as was allocated $39,000 of service department costs The allocations of service department costs for year two are as shown Notice: a The Suits Department increased sales by $100,000 while the other departments’ sales remained unchanged b The allocation of service department costs to the Suits Department increased by $4,200 while it decreased in the other two departments c The manager of the Suits Department is likely to complain 1065 63 1066 63 that as a result of his efforts to expand sales, he is being forced to carry a larger share of the service department costs Helpful Hint: Ask students to suppose they are a division manager in a company that allocates fixed costs on the basis of actual sales Ask if the fixed costs allocated to their division will depend on sales in other divisions If they say yes, ask if this fair There will probably be a chorus of no’s Ask how this differs from grading on a curve After some direction, they should conclude that if you better on an exam than others, your grade will be higher and other students’ grade will be lower However, if your sales increase relative to other divisions, the fixed costs allocated to you will increase and that allocated to other divisions will decrease 1067 Chapter 15 Transparency Masters 1068 TM 15-1 AGENDA: SERVICE DEPARTMENT COSTING, AN ACTIVITY APPROACH A Reasons for allocating service department costs to operating departments B The two-stage allocation process C Bases commonly used to allocate service department costs D Reciprocal services E The step method F The direct method G Allocating costs by behavior; the allocation guidelines H Implementation of the allocation guidelines © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-2 REASONS FOR ALLOCATING SERVICE DEPARTMENT COSTS Service department costs are allocated to operating departments for a variety of reasons: To encourage managers of operating departments to make wise use of services provided by service departments To provide more complete cost data for making decisions in operating departments To help measure profitability in operating departments To put pressure on service departments to operate efficiently To develop overhead rates in the operating departments for costing products To help determine the cost base for cost-plus pricing © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-3 TWO STAGE ALLOCATION PROCESS (Exhibit 15-5) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-4 BASES COMMONLY USED TO ALLOCATE SERVICE DEPARTMENT COSTS (Exhibit 15-1) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-5 RECIPROCAL SERVICES Services that service departments provide to each other are known as reciprocal or interdepartmental services The approaches commonly used to allocate the costs of service departments are the direct method, the step method, and the reciprocal method • The direct method ignores reciprocal services Service department costs are allocated directly to operating departments • The step method provides for the allocation of a service department’s costs to other service departments, as well as to operating departments This sequential method takes into account many of the reciprocal services, but not all of them • Unlike the direct and step methods, the reciprocal method fully accounts for all of the reciprocal services However, the mathematics of the reciprocal method are relatively complex and it is seldom used © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-6 GRAPHIC ILLUSTRATION OF THE STEP METHOD (Exhibit 15-3) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-7 STEP METHOD When allocating costs by the step method, the sequence begins with the department that provides the greatest amount of service to other departments In the example that follows, Personnel Department costs are allocated on the basis of number of employees and Custodial Services Department costs are allocated on the basis of space occupied: Departmental costs Number of employees Space occupied-square feet Personnel Custodial Services Machining $720,000 20 9,000 $180,000 10 6,000 $ 970,000 100 30,000 $720,000 $180,000 45,000 Assembly Total $ 630,000 50 70,000 $2,500,000 180 115,000 $ 970,000 $630,000 $2,500,000 450,000 225,000 (225,000) 7,500 $ $1,487,500 157,500 $1,012,500 The step allocation would proceed as follows: Departmental costs before allocation Allocations: Personnel costs (10/160, 100/160, 50/160)* Custodial services costs (30/100, 70/100)** Total cost after allocations (720,000) $ $2,500,000 *Based on: 10 + 100 + 50 = 160 (Or, $720,000 ÷ 160 employees = $4,500 per employee.) **Based on: 30,000 + 70,000 = 100,000 (Or, $225,000 ÷ 100,000 square feet = $2.25 per square foot) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-8 DIRECT METHOD Although the direct method is simpler than the step method, it is less accurate since it ignores interdepartmental services Again assume the following data: Departmental costs Number of employees Space occupied-square feet Personnel $720,000 20 9,000 Custodial Services Machining $180,000 10 6,000 $ 970,000 100 30,000 $180,000 Assembly Total $ 630,000 50 70,000 $2,500,000 180 115,000 $ 970,000 $630,000 $2,500,000 480,000 240,000 (180,000) 54,000 $ $1,504,000 126,000 $996,000 The direct method allocation would proceed as follows: Departmental costs before allocation Allocations: Personnel costs (100/150, 50/150)* Custodial services costs (30/100, 70/100)** Total cost after allocations $720,000 (720,000) $ $2,500,000 *Based on: 100 + 50 = 150 (Or, $720,000 ÷ 150 employees = $4,800 per employee.) **Based on: 30,000 + 70,000 = 100,000 (Or, $180,000 ÷ 100,000 square feet = $1.80 per square foot) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-9 ALLOCATING COSTS BY BEHAVIOR Whenever possible, fixed and variable service department costs should be allocated separately using the following guidelines: • Variable costs should be charged at a budgeted rate based on the activity that causes the cost (If actual service department costs are allocated, the operating departments are implicitly held responsible for how well the service departments control their spending.) • Allocations at the beginning of the period: Cost allocated = Budgeted rate × Budgeted activity • Allocations at the end of the period: Cost allocated = Budgeted rate × Actual activity • Fixed costs are incurred to provide capacity Therefore, fixed costs should be allocated to consuming departments in predetermined lump-sum amounts, in proportion to their demands for capacity (the department’s peak-period or long-run average needs) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-10 ALLOCATION EXAMPLE Implementation of the allocation guidelines is illustrated below EXAMPLE: White Company 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 for next year follow: Cutting Department Assembly Department Total Percentage of Peak Period Requirements 60% 40 100% Budgeted Hours 75,000 50,000 125,000 Actual Hours 80,000 40,000 120,000 The amount of Maintenance Department cost that would be allocated to each operating department at the beginning of the year is: Variable cost allocation: $0.60 per hour × 75,000 hours $0.60 per hour × 50,000 hours Fixed cost allocation: $200,000 × 60% $200,000 × 40% Total cost allocated Cutting Department Assembly Department $ 45,000 $ 30,000 120,000 $165,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved 80,000 $110,000 TM 15-11 ALLOCATION EXAMPLE (cont’d) At the end of the year, the allocation of variable costs should be based on actual activity Ordinarily, the amounts charged to the operating departments for services will be based on these end-ofperiod allocations Assume that actual Maintenance Department costs for the year are: variable, $0.65 per machine hour ($78,000 total); fixed, $210,000 Variable cost allocation: $0.60 per hour × 80,000 hours $0.60 per hour × 40,000 hours Fixed cost allocation: $200,000 × 60% $200,000 × 40% Total cost allocated Cutting Department Assembly Department $ 48,000 $ 24,000 120,000 80,000 $104,000 $168,000 Note that the variable costs are allocated according to the budgeted rate per hour, but using the actual activity, and that the fixed costs are allocated according to the original budgeted amount and peak-period demand Thus, some of the actual year-end costs are not be allocated (or charged out) to the consuming departments, as shown below: Actual costs incurred Costs allocated above Spending variance—not allocated Variable $78,000 72,000 $ 6,000 Fixed $210,000 200,000 $ 10,000 The spending variance is the responsibility of the Maintenance Department and is not charged to the departments that use the services of the Maintenance Department © The McGraw-Hill Companies, Inc., 2006 All rights reserved [...]... Pathology Lab” (page 731) • According to the accounting department of Waikato Hospital, the average cost per test in the hospital’s pathology lab had increased from NZ$5.90 to NZ$7.29 over a three year period • On the other hand, according to the management of the pathology lab, the cost per test had decreased from NZ$1.44 to NZ$1.42 over the same period • The accounting department included allocations... athletes in each intercollegiate sport 1037 8 9 11 1038 10 • Other service departments include Facilities, Sports Information, Academic Center, StudentAthletes Program, Office Supplies, Legal and Audit, Accounting Office, Marketing, and Administrative • 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