Chap06 Cost Allocation

Garrison, Noreen, Brewer, Cheng & Yuen
© 2015 McGraw-Hill Education

Cost Allocations
of Service Departments
Chapter 6
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen © 2015 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
2
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen
Cost Allocation and Charges for Services
Rendered
 Intercompany – different entities within the same
group
 Transfer pricing
 may help group’s tax planning
 may be monitored and scrutinized by tax
authorities and other interested regulating
bodies/agents.
 needs to be seen as an “arm’s length
transaction”
 Will be covered in Chapter 13 Appendix A
3
Learning Objective 1
Explain the major reasons for

the need for allocating
nonmanufacturing costs.
4
Service Department Charges
Operating Service
Departments Departments
Do not directly
Carry out central
engage in
purposes of
operating
organization.
activities.
5
Reasons for Charging Service Department
Costs
Service department costs are charged to operating
departments for a variety of reasons including:
To provide operating
To encourage
departments with
operating departments
more complete cost
to wisely use service
data for making
department resources.
decisions.
To help measure the To create an incentive

profitability of for service
operating departments to
departments. operate efficiently.
6
Management Needs
 Need to understand the full cost of providing a product or
service (including supporting costs) to make better decisions.
• 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 resources
• Ensuring long-term sustainability and competitiveness
7
Transfer Prices
The service department charges

considered can be viewed as a transfer
price that is charged for services
provided by service departments to
operating departments/companies
within the group.
Service
Departments
$ Operating
Departments
8
Factors to be Considered in the Cost Allocation
Approach and Intercompany/Interdepartmental charges
 Cost-benefit Evaluation
• Including tangible and intangible costs and benefits
 Cause and effect
• Absorption of cost based on who causes it
 Benefit Received
• Absorption of cost based on the ultimate benefactor
 Ability to Bear
• 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
9
Service Department Charges
Allocate costs of service

departments to other operating
departments/units using the cost
behavior concept.
11
Charging Costs by Behavior
Whenever possible,
variable and fixed
service department costs
should be charged
separately.
12
Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.
13
Charge fixed service department costs to

consuming departments in predetermined
lump-sum amounts that are based on the
consuming department’s peak-period or long-
run average servicing needs.
Are based on amounts of

Should not vary from
capacity each consuming
period to period.
department requires.
14
Should Actual or Budgeted Costs Be
Charged?
Budgeted variable
and fixed service department
costs should be charged to
operating departments.
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:
Allocate maintenance costs to the two operating departments.

16
Sipco: End of the Year
Actual hours
17
Sipco: End of the Year
Actual hours
Percent of peak-period capacity.

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:
Percent of
Peak-Period
Capacity Miles Miles
Hospitals Required Planned Used
Mercy 45% 15,000 16,000
Northside 55% 17,000 17,500
Total 100% 32,000 33,500
19
Quick Check 
How much ambulance service cost will be

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

allocated to Mercy Hospital at the end of the
year?
a. $121,200
b. $254,400
c. $139,500
d. $117,000
21
Pitfalls in Allocating Fixed Costs
Allocating fixed
costs using a variable Result
allocation base.
Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.
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.
23
Autos R Us – An Example
Autos R Us has one service department and three
sales departments, New Cars, Used Cars, and Car
Parts. The service department costs total $80,000
for both years in the example.
Contrary to good practice, Autos R Us allocates the
service department costs based on sales.
24
Autos R Us – First-year Allocation
Departments
New Used Parts Total
Sales by department $ 1,500,000 $ 900,000 $ 600,000 $ 3,000,000
Percentage of total sales 50% 30% 20% 100%
Allocation of service
department costs $ 40,000 $ 24,000 $ 16,000 $ 80,000
$1,500,000 ÷ $3,000,000 50% of $80,000
In the next year, the manager of the New Cars department

increases sales by $500,000. Sales in the other departments
are unchanged. Let’s allocate the $80,000 service department
cost for the second year given the sales increase.
25
Autos R Us – Second-year Allocation
Departments
New Used Parts Total
Sales by department $ 2,000,000 $ 900,000 $ 600,000 $ 3,500,000
Percentage of total sales 57% 26% 17% 100%
Allocation of service
department costs $ 45,714 $ 20,571 $ 13,714 $ 80,000
$2,000,000 ÷ $3,500,000 57% of $80,000

If you were the manager of the New Cars department, would
you be happy with the increased service department
costs allocated to your department?
26
Service Department Allocations
Operating Departments
An operating department carries out

the central purpose of the organization
The
The Surgery Geography A
Department Department Production
at Mount at the Department
Sinai University of at
Hospital. Washington. Mitsubishi.
28
Service Departments
Service departments do not directly

engage in operating activities.
The The Human

Accounting Resources
Department Department
at Macy’s. at Walgreens.
29
Interdepartmental Services
Service Operating
Costs of the service
department become
overhead costs to
the operating
department
30
Allocation Approaches
Direct
Method

Step-Down 
Method
Reciprocal
Method

31
Reciprocal Services
Service Service
Department 1 Department 2
When service
departments provide
services to each
other we call them
reciprocal services.
32
Allocate service
department costs to
using the direct method.
33
Direct Method
Service Operating
Interactions Department Department
between service (Cafeteria) (Machining)
departments are
ignored and all
costs are
allocated directly
to operating Service Operating
departments. Department Department
(Custodial) (Assembly)
34
Direct Method – An Example
Service Department Allocation Base

Cafeteria Number of employees
Custodial Square feet occupied
35
How much of the Cafeteria and Custodial costs

should be allocated to each operating department
using the direct method of cost allocation?
36
20
$360,000 × = $144,000
20 + 30
Allocation base: Number of employees

37
30
$360,000 × = $216,000
20 + 30

38
25,000
$90,000 × = $30,000
25,000 + 50,000
Allocation base: Square feet occupied

39
50,000
$90,000 × = $60,000
25,000 + 50,000

40
To allocate service
department costs to
using the step-down
method.
41
Step-Down Method
Service Operating
Once a service (Cafeteria) (Machining)
department’s costs
are allocated,
other service
department costs
are not allocated
back to it.
Service Operating
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.
43
Step-Down Method – An Example
We will use the same data used

in the direct method example.
Service Department Allocation Base

Cafeteria Number of employees
Custodial Square feet occupied
44
Allocate Cafeteria costs first since

it provides more service than Custodial.
45
10
$360,000 × = $60,000
10 + 20 + 30

46
20
$360,000 × = $120,000
10 + 20 + 30

47
30
$360,000 × = $180,000
10 + 20 + 30

48
New total = $90,000 original Custodial cost

plus $60,000 allocated from the Cafeteria.
49
25,000
$150,000 × = $50,000
25,000 + 50,000

50
50,000
$150,000 × = $100,000
25,000 + 50,000

51
Reciprocal Method
Service Operating
Interdepartmental (Cafeteria) (Machining)
services are given
full recognition
rather than partial
recognition as with
the step method. Service Operating
Because of its mathematical complexity,

the reciprocal method is rarely used.
52
Quick Check Data
for Direct and Step-Down Methods
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
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
54
Quick Check 
How much cost will be allocated from

Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
20
$180,000 × = $36,000
20 + 80
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
56
Quick Check 

a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
18
$90,000 × = $13,500
18 + 102
57
Quick Check Data
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
58
Quick Check 

a. $35,250
b. $49,072
c. $18,000
d. $26,333
59
Quick Check 

ADMIN and BACS combined to the Accounting
Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
60
End of Chapter 6
61

Chap06 Cost Allocation

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Garrison, Noreen, Brewer, Cheng & Yuen

© 2015 McGraw-Hill Education

 This chapter will cover

 techniques and principles of allocation to be used

 allocation of service department costs to operating

 Will be covered in Chapter 13 Appendix A

Explain the major reasons for

To help measure the To create an incentive

The service department charges

Allocate costs of service

Charge fixed service department costs to

Are based on amounts of

Allocate maintenance costs to the two operating departments.

Percent of peak-period capacity.

How much ambulance service cost will be

How much ambulance service cost will be

$1,500,000 ÷ $3,000,000 50% of $80,000

In the next year, the manager of the New Cars department

$2,000,000 ÷ $3,500,000 57% of $80,000

An operating department carries out

Service departments do not directly

The The Human

Service Department Allocation Base

How much of the Cafeteria and Custodial costs

Allocation base: Number of employees

Allocation base: Number of employees

Allocation base: Square feet occupied

Allocation base: Square feet occupied

We will use the same data used

Service Department Allocation Base

Allocate Cafeteria costs first since

Allocation base: Number of employees

Allocation base: Number of employees

Allocation base: Number of employees

New total = $90,000 original Custodial cost

Allocation base: Square feet occupied

Allocation base: Square feet occupied

Because of its mathematical complexity,

The direct method of allocation is used.

How much cost will be allocated from

How much cost will be allocated from

How much total cost will be allocated from

How much total cost will be allocated from

The step method of allocation is used.

How much total cost will be allocated from

How much total cost will be allocated from

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