CHAPTER 15 SUPPORT DEPARTMENT, COMMON COST, AND REVENUE ALLOCATIONS LEARNING OBJECTIVES Differentiate the single-rate from the dual-rate cost-allocation method Understand how the uncertainty managers face is affected by the choice between budgeted and actual cost-allocation rates Allocate support department costs using the direct, step-down, and reciprocal methods Allocate common costs using either the stand-alone or the incremental method Explain the importance of explicit agreement between contracting parties when reimbursement is based on costs incurred Understand how bundling of products gives rise to revenue-allocation issues Allocate the revenues of a bundled package to the individual products in that package CHAPTER OVERVIEW Chapter 15 continues the study of the allocation of indirect costs—on the micro/application level The concept of cost allocation was introduced in Chapter in relation to a cost object A review of that information might be helpful at the beginning of the study of this chapter In Chapter 4, cost allocation becomes a focus The costing of a product or service using a normal costing system emphasizes the application of the allocation concept Again, the topic of cost allocation is studied through activity-based costing presented in Chapter With the introduction of budgets and standards, cost allocation is a main subject (Chapter 8) The first lines of this chapter recognize the pervasiveness of the topic and the difficulty in finding satisfactory answers to questions about cost allocation Chapter 14 gives the purpose for which cost is allocated as the starting point in the allocation process Three specific methods, direct, step-down, and reciprocal, for allocating costs of service or support departments to operating or production departments are described and illustrated Two other methods for allocating common costs are also presented—stand-alone and incremental Importantly, the text covers the why and how of cost allocation between business segments Contract disputes that arise over the allocation of costs are also addressed Allocation is a pervasive concept and its application to revenues is included The bundling of multiple products to sell for a single price requires allocation of that price if a manager is to be held responsible for individual product revenues or profits or if bonuses are calculated on individual products The two methods illustrated for revenue allocation are methods used for allocation of costs—stand-alone method and incremental method Examples are used to explain details of each method Support Department, Common Costs, and Revenue Allocations 201 CHAPTER OUTLINE TEACHING TIP: In Chapter 4, the basic method by which costs are allocated was introduced as primary to a normal costing system In Chapter 8, the basic is changed to incorporate standards Allocation amount = Allocation rate x Usage of cost allocation base The following portion of the outline addresses the elements of this formula To allocate or not to allocate a particular cost is the first question Other questions follow: how to group costs to be allocated, what to use as the cost-allocation base, should cost behavior (fixed and variable) be incorporated into the allocation process, should the costs and cost-allocation levels used for the rate be budgeted ones or actual amounts, should the usage amount by which the rate is multiplied be budgeted or actual amounts, and what specific method to use—direct to primary unit, step-down through other groupings on way to primary unit, or reciprocal of secondary groups sharing with each other to find amount for primary group? I Allocation formula issues Learning Objective 1: Differentiate the single-rate from the dual-rate cost-allocation method A Different methods of allocating fixed and variable costs: one rate for mixed cost or two rates using one for fixed costs and one for variable costs Single-rate cost-allocation method a Pools all costs regardless of behavior in a cost pool b Allocates to cost object using same rate per unit of single allocation base c Cost to implement is low—avoids often expensive analysis to classify individual cost items into fixed and variable categories d Often leads to decisions in own best interests of individual manager but not best interest for organization as a whole Dual-rate cost-allocation method a Pools cost into two separate cost pools according to behavior—fixed and variable b Allocates to cost object with each cost pool using different cost-allocation base c Signals to managers how costs behave differently d Provides better information for making decisions (should be method used) Do multiple choice Learning Objective 2: 202 Chapter 15 Assign Exercise 15-16 Understand how the uncertainty managers face is affected by the choice between budgeted and actual cost-allocation rates B Different rates to use for allocation: budgeted cost rates or actual cost rates Budgeted cost rates a Rates known in advance reduce uncertainty b Users can determine amount of service to request as rates known in advance c Managers motivated to improve efficiency bear risk of unfavorable cost variances Actual cost rates a Rates not known until end of period b Amounts allocated fluctuate so users bear the risk C Different usage quantities of fixed costs in allocating: budgeted or actual quantities [Exhibit 151] Budgeted quantity usage a Helps in planning, especially for long run b Unaffected by variations in other divisions c Requires realistic estimates, accurate forecasts Actual quantity usage—not known until end of period Practical capacity supplied a Each division only charges for actual use b Variations in actual use in one division not affect costs allocated to other divisions c Costs of unused capacity are highlighted and not allocated to user divisions Do multiple choice Assign Exercises 15-17 and 15-18 and Problems 15-28 and15-30 II Allocation methods to use for reciprocal relationships A Distinguishing between types of departments within an organization Operating department or production department: directly adds value to a product or service Support department or service department Support Department, Common Costs, and Revenue Allocations 203 a Assists other internal departments in the company b Creates special allocation problems when providing reciprocal support to each other as well as operating departments c Results in more accurate costs of products, services, and customers when more accurate in support department allocations [Exhibit 15-2] Learning Objective 3: Allocate support department costs using the direct, step-down, and reciprocal methods B Distinguishing among specific allocation methods for allocating support costs Direct allocation method [Exhibit 15-3] a Most widely used method of allocating support department costs b Allocates each support department’s costs directly to operating departments c Benefit of simplicity d Disadvantage is failure to recognize reciprocal services provided among support departments Step-down allocation method (also called sequential allocation method) [Exhibit 15-4] a Allows for partial recognition of services rendered by support departments to other support departments b Requires support departments to be ranked (sequenced) in the order of the allocation c Often uses department with highest percentage of its total services to other service departments to start allocation sequence, with next-highest following, etc d Does not recognize total services that support departments provide each other Reciprocal allocation method [Exhibit 15-5] a Allocates costs by explicitly including mutual services provided among all support departments b Conceptually most precise method because considers mutual services provided among all support departments c Highlights complete reciprocated costs of support departments and how those costs differ from budgeted or actual costs of departments—key input for decisions about outsourcing d Requires three steps: [Exhibit 15-6] i 204 Chapter 15 Step 1: Express support department costs and support department reciprocal relationships in the form of linear equations ii Step 2: Solve the set of linear equations to obtain the complete reciprocated costs of each support department iii Step 3: Allocate the complete reciprocated costs of each support department to all other departments (both support departments and operating departments) on the basis of the usage percentages (based on total units of service provided to all departments) [Surveys of Company Practice] TEACHING TIP: Use a sentence in words about the costs of a support department before developing the equation From the text example—the full cost of the Plant Maintenance support department is or equals $600,000 plus costs used by Plant Maintenance that were supplied by Information Systems (The terms of used by [use column] and supplied by [use row] are helpful when using the format of exercises and problems in the text.) Substituting mathematical symbols in place of the words will develop the equation Do multiple choice 3, 4, and Assign Exercises 15-19 (20) and 15-21 (22) and Problems 1531, 15-32, and 15-33 III Methods of allocating common costs A Common cost: cost of operating a facility, activity, or like cost object that is shared by two or more users Learning Objective 4: Allocate common costs using either the stand-alone or incremental method B Methods for allocating Stand-alone cost-allocation method a Uses information pertaining to each user of a cost object as a separate entity to determine the cost-allocation weights b Emphasizes fairness or equity criterion because each user bears a proportionate share of total costs in relation to individual stand-alone costs Incremental cost-allocation method a Ranks individual users of a cost object in order of users most responsible for the common costs, then uses this ranking to allocate costs among users b Disputes as to which is incremental user A caution—chosen method of allocation should be acceptable to each user Do multiple choice Assign Exercises 15-23 and 15-24 Support Department, Common Costs, and Revenue Allocations 205 Learning Objective 5: Explain the importance of explicit agreement between contracting parties when reimbursement is based on costs incurred IV Cost allocation and Contracts A Reduce disputes by making “rules of the game” explicit and in writing at time of contract signing Definition of cost items allowed Definition of terms used Permissible cost-allocation bases Handling of accounting for differences between budgeted and actual costs B Complex interplay of political considerations and accounting principles Reimbursement: contractor paid set price without analysis of actual contract cost data a Competitive bidding b Adequate price competition c Established catalog with prices quoted for items sold in substantial quantities to general public Reimbursement: contractor paid after analysis of actual contract cost data: cost-plus contract a Compliance with Cost Accounting Standards Board: for uniformity and consistency in regard to measurement, assignment, and allocation of costs b Terms such as “fairness” and “equity” often used along with cause and effect and benefits received C Fairness of pricing [Concepts in Action] Costs-plus-fixed-fee contracts a Initiating party assumes major share of risk of potentially high costs of completing contract b Use of allowable costs: cost contract parties agree to include in costs to be reimbursed Do multiple choice Assign Problem 15-35 TEACHING TIP: In calculating proportions or weights to use in allocating, it is sometimes helpful to remind students that order is not important in multiplication and division The amount of cost allocated will be the same whether one uses the sequence (individual amount/total amount) (proportion) x cost to be allocated 206 Chapter 15 = allocated cost or (individual amount x cost to be allocated) / total amount individual amount x (cost to be allocated/total amount) (rate) I = allocated cost or = allocated cost Revenues A Essential to profit B Important to managers Revenue planning Revenue analysis V Revenue allocation Learning Objective 6: Understand how bundling of products gives rise to revenue-allocation issues A Revenue allocation and bundled products Definitions a Revenue allocation: assigning of revenues that are related, but cannot be traced in an economically feasible way to revenue object b Revenue object: anything for which a separate measurement of revenue is desired c Bundled product: package of two or more products or services, sold for a single price, but individual components of the bundle may be sold as separate items at their “standalone” prices Issues a Single price for bundled product typically less than sum of prices of individual products sold separately b Separate measurement (allocation) of revenue by product if manager responsible for individual product revenues or profits Do multiple choice Assignment follows L O Learning Objective 7: Allocate the revenues of a bundled package to the individual products in that package B Revenue allocation methods Stand-alone revenue-allocation method a Description: uses product-specific information on products in the bundle as weights for allocating bundled revenues to individual products Support Department, Common Costs, and Revenue Allocations 207 b Weights i Selling prices ii Unit costs iii Physical units in which each unit has the same weight iv Stand-alone product revenues c Advantages i Revenue as weight—selling price and stand-alone product revenues • Use of benefits-received criterion (revenue as benefit) • More weight to product that generates more revenue and drives sale of bundled products ii Physical units as weight • Ease of use • Less limitations than other methods if costs difficult to calculate or selling prices unstable Incremental revenue allocation method a Description: ranks individual products in a bundle according to criteria determined by management, then uses ranking to allocate the bundled revenues to the individual products b Ranking i Terms: first-ranked is primary product, second-ranked is first incremental product, third-ranked is second incremental product ii Criterion • Survey of customers as to relative importance of individual products in decision to purchase bundled products • Data on recent stand-alone performance of the individual products in the bundle • Top managers use their knowledge or intuition to decide the rankings iii Comparison to stand-alone method: stand-alone method less likely to cause acrimonious debates among product managers c Management judgment not explicitly based on specific formula Do multiple choice and 10 208 Chapter 15 Assign Exercise 15-25 and Problem 15-34 CHAPTER QUIZ SOLUTIONS: 1.d 2.c 3.a 4.c 5.d 6.b 7.b 8.a 9.b 10.a CHAPTER QUIZ The use of a dual-rate cost-allocation method recognizes a b c d the improvements in technology allowing for use of multiple cost pools the need to use both budgeted and actual cost rates when allocating the need to use both budgeted and actual usage of quantities when allocating the behavior aspect of costs Managers are affected by risks they have to take and would prefer to use a b c d actual rates for cost allocation because the rates are calculated from real amounts actual rates for cost allocation because actual rates are easier to justify to users budgeted rates for cost allocation because the rates are known in advance budgeted rates for cost allocation because any variances are transferred to users The following data apply to questions 3–5 Billy Stone, Inc., budgets the following amounts for its Buildings & Grounds and Computer Services Departments in servicing each other and the two manufacturing divisions of Signs and Mailers: Supplied By Building & Grounds Buildings & Grounds Computer Services Used By Computer Services — 0.15 0.20 — Signs Mailers 0.60 0.30 0.20 0.55 Signs Mailers 0.60 0.35 0.30 0.40 The actual results for the time period were as follows: Supplied By Building & Grounds Buildings & Grounds Computer Services — 0.25 Used By Computer Services 0.10 — Actual cost data for each department are: Buildings & Grounds Computer Services Fixed $ 50,000 $100,000 Variable $90,000 $21,000 Total fixed costs allocated from Buildings & Grounds to the Signs Department, using the preferred allocation basis, by the direct allocation method are a $37,500 b $33,333 c $30,000 d $25,000 Total variable costs allocated from Computer Services to Mailers Department, using the preferred allocation basis, by the step-down allocation method (begin with Building & Grounds) are a $8,400 b $12,000 c $16,000 d $25,235 The equation to determine the total variable costs of Computer Services using the preferred allocation basis, for the reciprocal allocation method is Support Department, Common Costs, and Revenue Allocations 209 a CS = $21,000 + 0.25 B&G b CS = $21,000 + 0.20 B&G c CS = $21,000 + 0.15 B&G d CS = $21,000 + 0.10 B&G If a cost is incurred for more than one user, that cost is considered a(n) a b c d homogeneous cost common cost stand-alone cost incremental cost Which of the following is often the most basic cause of contract disputes? a b c d allowable costs cost-allocation issues use of common costs writing into the contract “rules of the game” Bundling of products creates the need for revenue allocation for each of the following except when a b c d selling prices for the bundle are set to recoup the stand-alone prices of each product in the bundle the manager is responsible for profitability on a product-by-product basis the manager’s bonus is based upon product profitability persons involved with product development are compensated by percentage of revenues realized Use the following information for questions and 10 Trio Company sells three products, Do, Ra, and Mi, for prices of $8, $7, and $5, respectively They also offer combinations of the products for reduced overall prices The following packages are available: (1) a package containing Do and Ra sells for $13.50, (2) a package of Do and Mi sells for $11.50, (3) a package containing Ra and Mi sells for $10.50, and (4) a package of all three products, Do, Ra, and Mi, sells for $17.00 If Trio Company uses the stand-alone method (based on selling prices) to allocate revenues to products, the amount of revenues to be allocated to Do from a package of all three products, as described in (4) above, sold would be a $8.00 b $6.80 c $5.95 d $4.25 10 If Trio Company uses the incremental-revenues allocation method and has designated Ra as the primary product, the amount of revenues from a bundled package of all three products to be allocated to Ra would be a $7.00 210 Chapter 15 b $6.80 c $5,95 d $4.25 WRITING/DISCUSSION EXERCISES Differentiate the single-rate from the dual-rate cost-allocation method Is the caution to “beware of unit costs” applicable to the single-rate cost-allocation method? Why or why not? The caution is probably applicable The situation could exist such that the indirect costs to be allocated were homogeneous, all variable in behavior, and linked in a cause-andeffect manner to the same cost-allocation base If such a situation existed, the single rate would probably work A test could be applied: if the costs were individually allocated, would they require the use of the same cost-allocation base? If the answer were yes, then a single pool would be appropriate However, the caution of using a single rate (unit cost) pertains to unitizing fixed costs Fixed costs, by definition, stay the same in total but vary per unit The cost pool from which the single rate would be calculated could contain some fixed costs—and the caution would apply Understand how the uncertainty managers face are affected by the choice between budgeted and actual cost-allocation rates What has the manager of a supplier department to lose when s/he is not directly affecting the product or service? Managers of supplier or support departments are at risk when the actual costs of their department exceed their budgeted costs If a budgeted rate is used, a manager risks actual costs of providing the service being greater than the budget amount with no one to pass those additional costs on to Another risk for a manager is that the users of the department’s service will go elsewhere to “buy” the service, and department costs will exceed revenues If the excess costs are due to events over which the manager has no control, some arrangement could be made so the manager does not have the full burden In some instances, top management may wish to provide various incentives that would benefit the organization as a whole, but might be viewed negatively by an individual manager Agreements could be made to share the risk across departments rather than have only one manager responsible Allocate support department costs using the direct, step-down, and reciprocal methods Why is it so important that managers have some understanding of cost accounting? The statement will often be made that one method has an advantage of being relatively simple to compute and understand as opposed to some other method The simple method is usually the one most in use This would lead one to believe that when using the cost/benefit approach, more often the easier method is best Consider the reciprocal method for allocating costs It is the superior method for accuracy of capturing interdepartmental relationships, resulting in better-informed decisions about the performance of a department and the company as a whole Yet, the reciprocal method is not widely used A defense for nonuse could be made before technology became available and common If a manager is aware that by using more sophisticated models, s/he will gain greater benefits, their use should be required The learning necessary to glean full advantage would carry a cost, but that cost would be less than the reward furnished by the knowledge available in the long run Support Department, Common Costs, and Revenue Allocations 211 Allocate common costs using either the stand-alone or incremental method Give an example of a situation in which two or more users share a common cost and offer a way for the users to share the cost Many examples are possible The method by which the cost could be shared would probably be some version of either the stand-alone or incremental methods One example is buying a box of items at an auction One person, for the benefit of several other persons, made the purchase Each person wanted one or two items (no one wanted the same item) in the box In this situation, the cost of the box must be allocated among the various partakers of the items in the box because none of the cost could be traced to an individual item Common costs are typically package deals and are less in amount for the users than if each user acted alone—requiring allocation Explain the importance of explicit agreement between contracting parties when reimbursement is based on costs incurred How does the phrase “hindsight has 20/20 vision” apply to contract disputes having to with cost allocation? Before the work contracted for is commenced, all of the situations and problems cannot be anticipated Usually neither party wants to assume all of the risk, so if loss does occur, the question of how that loss is to be shared is fraught with controversy In some situations, cultural traditions or taboos are not negotiated ahead of signing the contract because the one party assumes that anyone would know and understand them, whereas the other party is unaware that such customs or taboos exist In the process of doing the work, if a cost is incurred that violates a tradition, a disagreement will occur as to the propriety of the cost and who will bear it Many other possibilities for disagreement exist as to which party bears a cost when reimbursement is based on costs incurred even when an explicit agreement exists between parties Understand how bundling of products gives rise to revenue-allocation issues Revenue assignment to a revenue object involves both revenue tracing and revenue allocation Revenue tracing occurs where revenues can be identified with an individual product, service, or customer in an economically feasible way What is done with deductions in revenue, such as sales returns, when revenues are traced to revenue objects? Revenue tracing, like cost tracing, results in more accurate assignment of revenues to products than revenue allocation More accurate revenue assignment results in more accurate information; more accurate information is believed to result in better decisions Any revenue-related items should also be traced to the related revenue object If revenue-related items, such as sales returns, are not traced but rather broadly averaged across all products, the information is not as accurate and affects decisions made As is noted in the text, the detail of records maintained about price-discounting affects the ability to customer profitability analysis [Refer to Chapter 14] The accuracy and detail of tracing revenues and revenue-related items, such as sales returns, also affect customer profitability analysis 212 Chapter 15 Allocate the revenues of a bundled package to the individual products in that package How does the illustration in the text [“Other Revenue-Allocation Methods”] of the president of a software company determining the revenue allocation weights for use with incremental method of allocating revenues reinforce the key guideline for management accounting that management is primarily a human activity? A management accounting system should improve the decisions made by managers and help motivate managers (and others) to achieve the company’s goals An important guideline in helping management accountants provide the most value in performing their functions is that of focusing on behavioral considerations—how to help individuals their jobs better In situations in which the need exists for revenue allocation, specific formulae, such as used in the stand-alone allocation method, are helpful management tools Factors, other than those incorporated in such formulae, may need to be considered Management judgment, a human activity, is needed The use of some methods is more dependent upon management judgment, the incremental allocation method as one example The specific example in the text illustrates the human element of difference of opinion between managers The accounting tool of incremental revenue allocation method existed to provide helpful information for making decisions but its implementation had to be handled primarily as a human activity and not an accounting procedure Support Department, Common Costs, and Revenue Allocations 213 SUGGESTED READINGS Anthony, R., “Cost Allocation,” Journal of Cost Analysis (Spring 1984) p.5 [11p] Balakrishnan, R and DeJong, D., “The Role of Cost Allocation in the Acquisition and Use of Common Resources,” The Accounting Review (July 1993) p.395 [20p] Ingram, R., Parsons, W., and Robbins, W., “Instructional Case: Oak City’s Cost Allocation and Determination,” Issues in Accounting Education (February 1998) p.157 [15p] Savage, K and Wilburn, N., “Teaching the Reciprocal Method of Service—Department Cost Allocation Using a Spreadsheet Approach,” Accounting Educators Journal (Fall 1997) p.142 [14p] Sharma, R and Ratnatunga, J., “Teaching Note: Traditional and Activity-Based Costing Systems,” Accounting Education (December 1997) p.337 [19p] Sutcliffe, C., “Aggregation and Reciprocal Service Cost Allocation,” Journal of Business Finance & Accounting (September 1991) p.721 [13p] 214 Chapter 15 [...]... The accounting tool of incremental revenue allocation method existed to provide helpful information for making decisions but its implementation had to be handled primarily as a human activity and not an accounting procedure Support Department, Common Costs, and Revenue Allocations 213 SUGGESTED READINGS Anthony, R., “Cost Allocation,” Journal of Cost Analysis (Spring 1984) p.5 [11p] Balakrishnan, R and. .. long run Support Department, Common Costs, and Revenue Allocations 211 4 Allocate common costs using either the stand-alone or incremental method Give an example of a situation in which two or more users share a common cost and offer a way for the users to share the cost Many examples are possible The method by which the cost could be shared would probably be some version of either the stand-alone... and who will bear it Many other possibilities for disagreement exist as to which party bears a cost when reimbursement is based on costs incurred even when an explicit agreement exists between parties 6 Understand how bundling of products gives rise to revenue- allocation issues Revenue assignment to a revenue object involves both revenue tracing and revenue allocation Revenue tracing occurs where revenues... the Acquisition and Use of Common Resources,” The Accounting Review (July 1993) p.395 [20p] Ingram, R., Parsons, W., and Robbins, W., “Instructional Case: Oak City’s Cost Allocation and Determination,” Issues in Accounting Education (February 1998) p .157 [15p] Savage, K and Wilburn, N., “Teaching the Reciprocal Method of Service—Department Cost Allocation Using a Spreadsheet Approach,” Accounting Educators... in revenue, such as sales returns, when revenues are traced to revenue objects? Revenue tracing, like cost tracing, results in more accurate assignment of revenues to products than revenue allocation More accurate revenue assignment results in more accurate information; more accurate information is believed to result in better decisions Any revenue- related items should also be traced to the related revenue. .. profitability analysis 212 Chapter 15 7 Allocate the revenues of a bundled package to the individual products in that package How does the illustration in the text [“Other Revenue- Allocation Methods”] of the president of a software company determining the revenue allocation weights for use with incremental method of allocating revenues reinforce the key guideline for management accounting that management is primarily... object If revenue- related items, such as sales returns, are not traced but rather broadly averaged across all products, the information is not as accurate and affects decisions made As is noted in the text, the detail of records maintained about price-discounting affects the ability to do customer profitability analysis [Refer to Chapter 14] The accuracy and detail of tracing revenues and revenue- related... Accounting Educators Journal (Fall 1997) p.142 [14p] Sharma, R and Ratnatunga, J., “Teaching Note: Traditional and Activity-Based Costing Systems,” Accounting Education (December 1997) p.337 [19p] Sutcliffe, C., “Aggregation and Reciprocal Service Cost Allocation,” Journal of Business Finance & Accounting (September 1991) p.721 [13p] 214 Chapter 15 ... activity? A management accounting system should improve the decisions made by managers and help motivate managers (and others) to achieve the company’s goals An important guideline in helping management accountants provide the most value in performing their functions is that of focusing on behavioral considerations—how to help individuals do their jobs better In situations in which the need exists for revenue. .. departments rather than have only one manager responsible 3 Allocate support department costs using the direct, step-down, and reciprocal methods Why is it so important that managers have some understanding of cost accounting? The statement will often be made that one method has an advantage of being relatively simple to compute and understand as opposed to some other method The simple method is usually