Methods for Allocating Support Department Costs and Revenues

1. CHAPTER 15 Allocation of Support Department Costs, Common Costs, and Revenues

2. Allocating Costs of a Supporting Department to Operating Departments • Supporting (Service) Department – provides the services that assist other internal departments in the company • Operating (Production) Department – directly adds value to a product or service

3. Methods to Allocate Support Department Costs • Single-rate method – allocates costs in each cost pool (service department) to cost objects (production departments) using the same rate per unit of a single allocation base • No distinction is made between fixed and variable costs in this method

4. Methods to Allocate Support Department Costs • Dual-Rate method – segregates costs within each cost pool into two segments: a variable-cost pool and a fixed-cost pool. • Each pool uses a different cost-allocation base

5. Allocation Method Tradeoffs • Single-Rate method is simple to implement, but treats fixed costs in a manner similar to variable costs • Dual-Rate method treats fixed and variable costs more realistically, but is more complex to implement

6. Allocation Bases • Under either method, allocation of support costs can be based on one of the three following scenarios: • Budgeted overhead rate and budgeted hours • Budgeted overhead rate and actual hours • Actual overhead rate and actual hours • Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period

7. Comparative Allocation Bases Illustrated

8. Methods of Allocating Support Costs to Production Departments • Direct • Step-Down • Reciprocal

9. Direct Method • Allocates support costs only to Operating Departments • No Interaction between Support Departments prior to allocation

10. Direct Method

11. Data Used in Cost Allocation Illustrations

12. Direct Allocation Method Illustrated

13. Direct Allocation Method Illustrated, cont.

14. Step-Down Method • Allocates support costs to other support departments and to operating departments that partially recognizes the mutual services provided among all support departments • One-Way Interaction between Support Departments prior to allocation

15. Step-Down Method

16. Step-Down Allocation Method Illustrated

17. Step-Down Allocation Method Illustrated, cont.

18. Reciprocal Method • Allocates support department costs to operating departments by fully recognizing the mutual services provided among all support departments • Full Two-Way Interaction between Support Departments prior to allocation

19. Reciprocal Method

20. Reciprocal Allocation Method (Repeated Iterations) Illustrated

21. Reciprocal Allocation Method (Linear Equations) Illustrated

22. Choosing Between Methods • Reciprocal is the most precise • Direct and Step-Down are simple to compute and understand • Direct Method is widely used

23. Allocating Common Costs • Common Cost – the cost of operating a facility, activity, or like cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user

24. Methods of Allocating Common Costs • Stand-Alone Cost-Allocation Method – uses information pertaining to each user of a cost object as a separate entity to determine the cost-allocation weights • Individual costs are added together and allocation percentages are calculated from the whole, and applied to the common cost

25. Methods of Allocating Common Costs • Incremental Cost-Allocation Method ranks the individual users of a cost object in the order of users most responsible for a common cost and then uses this ranking to allocate the cost among the users • The first ranked user is the Primary User and is allocated costs up the cost as a stand-alone user (typically gets the highest allocation of the common costs) • The second ranked user is the First Incremental User and is allocated the additional cost that arises from two users rather than one • Subsequent users handled in the same manner as the second ranked user

26. Cost Allocations and Contracting • The US government reimburses most contractors in either of two main ways: • The contractor is paid a set price without analysis of actual contract cost data. • The contractor is paid after an analysis of actual contract cost data. In some cases, the contract will state that the reimbursement amount is based on actual allowable costs plus a fixed fee (cost-plus contract)

27. Revenue Allocation and Bundled Products • Revenue Allocation occurs when revenues are related to a particular revenue object but cannot be traced to it in an economically feasible manner • Revenue Object – anything for which a separate measurement of revenue is desired • Bundled Product – a package of two or more products or services that are sold for single price, but individual components of the bundle also may be sold as separate items at their own “stand-alone” prices

28. Methods to Allocate Revenue to Bundled Products • Stand-Alone (separate) Revenue Allocation Method uses product-specific information on the products in the bundle as weights for allocating the bundled revenues to the individual products. Three types of weights may be used: • Selling Prices • Unit Costs • Physical Units

29. Methods to Allocate Revenue to Bundled Products • Incremental Revenue-Allocation Method ranks individual products in a bundle according to criteria determined by management and then uses this ranking to allocate bundled revenues to individual products (similar to earlier discussed Incremental Cost-Allocation Method) • The first-ranked product is the primary product • The second-ranked product is the first incremental product • The third-ranked product is the second incremental product, etc