Chap 006

Cost Allocation
Chapter 6
2012 McGraw-Hill Education (Asia)
Cost Allocation and Charges for Services

Rendered
Intracompany inside the same entity
This chapter will cover

reasons for establishment of an internal service
charging system or to have an cost allocation system
techniques
and principles of allocation to be used
allocation
of service department costs to operating

departments using the direct and step-down methods
McGraw-Hill Education (Asia)

McGraw-Hill/Irwin
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 2
Cost Allocation and Charges for Services

Rendered
Intercompany different entities within the same

group
Transfer pricing
may help groups tax planning
may be monitored and scrutinized by tax authorities
and other interested regulating bodies/agents.
needs to be seen as an arms length transaction
Will be covered in Chapter 13 Appendix A

McGraw-Hill/Irwin
Slide 3
Learning Objective 1
Explain the major reasons for
the need for allocating
nonmanufacturing costs.

McGraw-Hill/Irwin
Slide 4
Service Department Charges
Operating
Departments
Service
Departments
Carry out central

purposes of
organization.
Do not directly
engage in
operating
activities.

McGraw-Hill/Irwin
Slide 5
Reasons for Charging Service Department

Costs
Service department costs are charged to operating
departments for a variety of reasons including:
To
To encourage
encourage
operating
operating departments
departments
to
to wisely
wisely use
use service
service
department
department resources.
resources.
To
To provide
provide operating
operating
departments
departments with
with
more
more complete
complete cost
cost
data
data for
for making
making
decisions.
decisions.
To
To help
help measure
measure the
the
profitability
profitability of
of
operating
operating
departments.
departments.
To
To create
create an
an incentive
incentive
for
for service
service
departments
departments to
to
operate
operate efficiently.
efficiently.

McGraw-Hill/Irwin
Slide 6
Management Needs
Need to understand the full cost of providing a

product or service (including supporting costs) to
make better decision.
Ensuring competitive costing and pricing
Assessment of risk and potential success of

the product/service
Financial and operational forecasts and

planning
Motivating performance evaluation and

reward system
Communicating to employees about the

importance of recovering all indirect costs
Encouraging efficient and effective use of

McGraw-Hill/Irwin
Slide 7
Transfer Prices
The
The service
service department
department charges
charges
considered
considered can
can be
be viewed
viewed as
as aa transfer
transfer
price
price that
that is
is charged
charged for
for services
services
provided
provided by
by service
service departments
departments to
to
operating
operating departments/companies
departments/companies
within
within the
the group.
group.
Service
Departments
McGraw-Hill/Irwin
$
Operating
Departments
Slide 8
Factors To Be Considered For The Cost Allocation

Approach and Intercompany/Interdepartmental charges
Cost-benefit Evaluation
Cause and effect
Absorption of cost based on the ultimate benefactor
Ability to Bear
Absorption of cost based on who causes it
Benefit Received
Including tangible and intangible costs and benefits
Absorption of cost based on who/which product has

the ability and profit margin to bear the cost
Fairness or Equity
Ensuring fair game and decent profit to motive

service provider, for example, use of a cost-plus
performance based award fee approach, to ensure
quality delivery of
service/product
Garrison,
Noreen, Brewer, Cheng & Yuen
McGraw-Hill/Irwin
Slide 9
Service Department Charges
Allocate costs of service
departments to other operating
departments/units using the cost
behavior concept.

McGraw-Hill/Irwin
Slide 11
Charging Costs by Behavior
Whenever possible,
variable and fixed
service department costs
should be charged
separately.

McGraw-Hill/Irwin
Slide 12

Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.

McGraw-Hill/Irwin
Slide 13

Charge
Charge fixed
fixed service
service department
department costs
costs to
to
consuming
consuming departments
departments in
in predetermined
predetermined
lump-sum
lump-sum amounts
amounts that
that are
are based
based on
on the
the
consuming
consuming departments
departments peak-period
peak-period or
or
long-run
long-run average
average servicing
servicing needs.
needs.
Are based on amounts of
capacity each consuming
department requires.
McGraw-Hill/Irwin
Should not vary from

period to period.
Slide 14
Should Actual or Budgeted Costs Be

Charged?
Budgeted variable
and fixed service department
costs should be charged to
operating departments.

McGraw-Hill/Irwin
Slide 15
Sipco: An Example
Sipco 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 to the current year are:
Operating
Departments
Cutting
Assembly
Total hours
Percent of
Peak-Period
Capacity
Required
60%
40%
100%
Hours
Planned
75,000
50,000
125,000
Hours
Used
80,000
40,000
120,000
Allocate maintenance costs to the two operating departments.

McGraw-Hill/Irwin
Slide 16
Sipco: End of the Year

Actual hours

McGraw-Hill/Irwin
Slide 17
Sipco: End of the Year

Actual hours
Percent of peak-period capacity.

McGraw-Hill/Irwin
Slide 18
Quick Check
Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable
ambulance costs are budgeted at $4.20 per mile.
Fixed ambulance costs are budgeted at $120,000
per year. Data relating to the current year are:
Hospitals
Mercy
Northside
Total
McGraw-Hill/Irwin
Percent of
Peak-Period
Capacity
Required
45%
55%
100%
Miles
Planned
15,000
17,000
32,000
Miles
Used
16,000
17,500
33,500
Slide 19
Quick Check
How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to
to Mercy
Mercy Hospital
Hospital at
at the
the end
end of
of the
the
year?
year?
a.
a. $121,200
$121,200
b.
b. $254,400
$254,400
c.
c. $139,500
$139,500
d.
d. $117,000
$117,000

McGraw-Hill/Irwin
Slide 20
Quick Check
How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to
to Mercy
Mercy Hospital
Hospital at
at the
the end
end of
of the
the
year?
year?
a.
a. $121,200
$121,200
b.
b. $254,400
$254,400
c.
c. $139,500
$139,500
d.
d. $117,000
$117,000

McGraw-Hill/Irwin
Slide 21
Pitfalls in Allocating Fixed Costs

Allocating fixed
costs using a variable
allocation base.

McGraw-Hill/Irwin
Slide 22
Pitfalls in Allocating Fixed Costs

Using sales
dollars as an
allocation base.
Result
Sales of one department
influence the service
department costs
allocated to other
departments.

McGraw-Hill/Irwin
Slide 23
Autos R Us An Example
Autos
Autos R
R Us
Us has
has one
one service
service department
department and
and three
three
sales
sales departments,
departments, New
New Cars,
Cars, Used
Used Cars,
Cars, and
and Car
Car
Parts.
Parts. The
The service
service department
department costs
costs total
total $80,000
$80,000
for
for both
both years
years in
in the
the example.
example.
Contrary
Contrary to
to good
good practice,
practice, Autos
Autos R
R Us
Us allocates
allocates the
the
service
service department
department costs
costs based
based on
on sales.
sales.

McGraw-Hill/Irwin
Slide 24
Autos R Us First-year Allocation
$1,500,000 $3,000,000
50% of $80,000
In
In the
the next
next year,
year, the
the manager
manager of
of the
the New
New Cars
Cars department
department
increases
increases sales
sales by
by $500,000.
$500,000. Sales
Sales in
in the
the other
other departments
departments
are
are unchanged.
unchanged. Lets
Lets allocate
allocate the
the $80,000
$80,000 service
service department
department
cost
cost for
for the
the second
second year
year given
given the
the sales
sales increase.
increase.
McGraw-Hill/Irwin
Slide 25
Autos R Us Second-year Allocation
$2,000,000 $3,500,000
57% of $80,000
IfIf you
you were
were the
the manager
manager of
of the
the New
New Cars
Cars department,
department, would
would
you
you be
be happy
happy with
with the
the increased
increased service
service department
department
costs
costs allocated
allocated to
to your
your department?
department?
McGraw-Hill/Irwin
Slide 26
Service Department Allocations
Operating Departments
An operating department carries out
the central purpose of the organization
The Surgery
Department
at Mount
Sinai
Hospital.

McGraw-Hill/Irwin
The
Geography
Department
at the
University of
Washington.
A
Production
Department
at
Mitsubishi.
Slide 28
Service Departments
Service departments do not directly
engage in operating activities.
The
Accounting
Department
at Macys.

McGraw-Hill/Irwin
The Human
Resources
Department
at Walgreens.
Slide 29
Interdepartmental Services
Service
Department
Operating
Department
Costs of the service

department become
overhead costs to
the operating
department

McGraw-Hill/Irwin
Slide 30
Allocation Approaches

McGraw-Hill/Irwin
Slide 31
Reciprocal Services
Service
Department 1
Service
Department 2
When service
departments provide
services to each
other we call them
reciprocal services.

McGraw-Hill/Irwin
Slide 32
Allocate service
department costs to
using the direct method.

McGraw-Hill/Irwin
Slide 33
Direct Method

McGraw-Hill/Irwin
Service
Department
(Cafeteria)
Operating
Department
(Machining)
Service
Department
(Custodial)
Operating
Department
(Assembly)
Slide 34
Direct Method An Example
Departmental costs
before allocation
Number of employees
Square feet occupied

McGraw-Hill/Irwin
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
15
5,000
$ 90,000
10
2,000
$ 400,000
20
25,000
$ 700,000
30
50,000
Slide 35

Service Departments
Cafeteria
Custodial
Machining
Assembly
Departmental costs
before allocation
$ 360,000
$ 90,000
$ 400,000
$ 700,000
Cafeteria allocation
Custodial allocation
Total after allocation
How much of the Cafeteria and Custodial costs

should be allocated to each operating department
using the direct method of cost allocation?
McGraw-Hill/Irwin
Slide 36
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
(360,000)
144,000
Allocation base: Number of employees

McGraw-Hill/Irwin
Slide 37
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
144,000
216,000
(360,000)
$360,000
30
= $216,000
20 + 30

McGraw-Hill/Irwin
Slide 38
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
144,000
216,000
(360,000)
(90,000)
$
25,000
$90,000
25,000 + 50,000
30,000
$ 574,000
= $30,000
Allocation base: Square feet occupied

McGraw-Hill/Irwin
Slide 39
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
144,000
216,000
30,000
60,000
$ 574,000
$ 976,000
(360,000)
(90,000)
$

McGraw-Hill/Irwin
Slide 40
To allocate service
department costs to
using the step-down
method.

McGraw-Hill/Irwin
Slide 41
Step-Down Method
Once a service
departments costs
are allocated,
other service
department costs
are not allocated
back to it.

McGraw-Hill/Irwin
Service
Department
(Cafeteria)
Operating
Department
(Machining)
Service
Department
(Custodial)
Operating
Department
(Assembly)
Slide 42
Step-Down Method
There are three key points to understand regarding
the step-down method:
In both the direct and step-down methods, any
amount of the allocation base attributable to the
service department whose cost is being allocated is
always ignored.
Any amount of the allocation base that is
attributable to a service department whose cost has
already been allocated is ignored.
Each service department assigns its own costs to
operating departments plus the costs that have
been allocated to it from other service departments.
McGraw-Hill/Irwin
Slide 43
Step-Down Method An Example

We will use the same data used
in the direct method example.
Departmental costs
before allocation
Number of employees
Square feet occupied

McGraw-Hill/Irwin
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
15
5,000
$ 90,000
10
2,000
$ 400,000
20
25,000
$ 700,000
30
50,000
Slide 44

Service Departments
Cafeteria
Custodial
Machining
Assembly
Departmental costs
before allocation
$ 360,000
$ 90,000
$ 400,000
$ 700,000
Allocate
Allocate Cafeteria
Cafeteria costs
costs first
first since
since
itit provides
provides more
more service
service than
than Custodial.
Custodial.
McGraw-Hill/Irwin
Slide 45
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
(360,000)
60,000
10
$360,000
10 + 20 + 30
= $60,000

McGraw-Hill/Irwin
Slide 46
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
(360,000)
20
$360,000
10 + 20 + 30
= $120,000

McGraw-Hill/Irwin
Slide 47
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(360,000)
30
$360,000
10 + 20 + 30
= $180,000

McGraw-Hill/Irwin
Slide 48
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(360,000)
(150,000)
$
New total = $90,000 original Custodial cost

plus $60,000 allocated from the Cafeteria.

McGraw-Hill/Irwin
Slide 49
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(150,000)
50,000
$ 570,000
(360,000)
25,000
$150,000
25,000 + 50,000
= $50,000

McGraw-Hill/Irwin
Slide 50
Departmental costs
before allocation
Service Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(150,000)
50,000
100,000
$ 570,000
$ 980,000
(360,000)
50,000
$150,000
25,000 + 50,000
= $100,000

McGraw-Hill/Irwin
Slide 51
Reciprocal Method
Interdepartmental
services are given
full recognition
rather than partial
recognition as with
the step method.
Service
Department
(Cafeteria)
Operating
Department
(Machining)
Service
Department
(Custodial)
Operating
Department
(Assembly)
Because of its mathematical complexity,

the reciprocal method is rarely used.
McGraw-Hill/Irwin
Slide 52
Quick Check Data

for Direct and Step-Down Methods
Service Departments
Departmental costs
before allocation
Number of employees
Number of PCs
ADMIN
BACS
Accounting
Others
$ 180,000
15
12
$ 90,000
5
20
$ 190,000
20
18
$ 900,000
80
102
The direct method of allocation is used.

Allocation bases:
Business school administration costs (ADMIN):
Number of employees
Business
Administration computer services (BACS):

Number of personal computers

McGraw-Hill/Irwin
Slide 53
Quick Check
How much cost will be allocated from
Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000

McGraw-Hill/Irwin
Slide 54
Quick Check
How much cost will be allocated from
Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000 Service Departments Operating Departments
BACS
Accounting
Others
d. $ 27,000 ADMIN
Departmental costs
before allocation
ADMIN allocation
$ 180,000
(180,000)
$ 90,000
$ 190,000
36,000
$ 900,000
144,000
20
$180,000
= $36,000
20 + 80
McGraw-Hill/Irwin
Slide 55
Quick Check
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500

McGraw-Hill/Irwin
Slide 56
Service Departments
Quick Check ADMIN
Departmental costs
before allocation
ADMIN
allocation
How
much
BACS allocation
BACS
Accounting
$ 180,000 $ 90,000
$ 190,000
(180,000)
36,000
total
cost will be allocated
(90,000)
13,500

Total after allocation $
$
$ 239,500
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500

McGraw-Hill/Irwin
Others
$
900,000
from144,000
76,500
$ 1,120,500
Slide 57
Quick Check Data

Service Departments
Departmental costs
before allocation
Number of employees
Number of PCs
ADMIN
BACS
Accounting
Others
$ 180,000
15
12
$ 90,000
5
20
$ 190,000
20
18
$ 900,000
80
102
The step method of allocation is used.

Allocation bases:
Business school administration costs (ADMIN):

Number of employees
Business administration computer services (BACS):
Number of personal computers

McGraw-Hill/Irwin
Slide 58
Quick Check
How much total cost will be allocated from
a. $35,250
b. $49,072
c. $18,000
d. $26,333

McGraw-Hill/Irwin
Slide 59
Quick Check
How much total cost will be allocated
from ADMIN and BACS combined to the
a. $35,250
b. $49,072
c. $18,000
d. $26,333

McGraw-Hill/Irwin
Slide 60
End of Chapter 6

McGraw-Hill/Irwin
Slide 61

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Cost Allocation

2012 McGraw-Hill Education (Asia)

Cost Allocation and Charges for Services

Intracompany inside the same entity

This chapter will cover

and principles of allocation to be used

of service department costs to operating

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Cost Allocation and Charges for Services

Intercompany different entities within the same

Will be covered in Chapter 13 Appendix A

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Service Department Charges

Carry out central

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Reasons for Charging Service Department

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Need to understand the full cost of providing a

Ensuring competitive costing and pricing

Assessment of risk and potential success of

Financial and operational forecasts and

Motivating performance evaluation and

Communicating to employees about the

Encouraging efficient and effective use of

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Factors To Be Considered For The Cost Allocation

Cause and effect

Absorption of cost based on the ultimate benefactor

Absorption of cost based on who causes it

Including tangible and intangible costs and benefits

Absorption of cost based on who/which product has

Ensuring fair game and decent profit to motive

Service Department Charges

2012 McGraw-Hill Education (Asia)

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Charging Costs by Behavior

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Charging Costs by Behavior

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Charging Costs by Behavior

Should not vary from

Garrison, Noreen, Brewer, Cheng & Yuen

Should Actual or Budgeted Costs Be

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Allocate maintenance costs to the two operating departments.

Garrison, Noreen, Brewer, Cheng & Yuen

Sipco: End of the Year

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Sipco: End of the Year

Percent of peak-period capacity.