Allocation of Support Department Costs Common Costs and

Allocation of Support Department Costs, Common Costs, and Revenues Chapter 15 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 1

Learning Objective 1 Differentiate the single-rate from the dual-rate cost-allocation method. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 2

Single-Rate and Dual-Rate Methods The single-rate cost allocation method pools together all costs in a cost pool. The dual-rate cost allocation method classifies costs in each cost pool into two cost pools – a variable-cost pool and a fixed-cost pool. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 3

Learning Objective 2 Understand how the uncertainty user managers face is affected by the choice between budgeted and actual cost-allocation rates. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 4

Budgeted versus Actual Rates Budgeted rates let the user department know in advance the cost rates they will be charged. During the budget period, the supplier department, not the user departments, bears the risk of any unfavorable cost variances. Why? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 5

Budgeted versus Actual Rates – because the user departments do not pay for any costs that exceed the budgeted rates When actual rates are used for cost allocation, managers do not know the rates to be used until the end of the budget period. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 6

Budgeted versus Actual Usage Allocation Bases Organizations commit to infrastructure costs on the basis of a long-run planning horizon. The use of budgeted usage to allocate these fixed costs is consistent with the long-run horizon. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 7

Learning Objective 3 Allocate support department costs using the direct, step-down, and reciprocal methods. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 8

Allocating Support Departments Costs An operating department (a production department in manufacturing companies) adds value to a product or service. A support department (service department) provides the services that assist other operating and support departments in the organization. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 9

Allocating Support Departments Costs Direct method: Allocates support department costs to operating departments only. Step-down (sequential allocation) method: Allocates support department costs to other support departments and to operating departments. Reciprocal allocation method: Allocates costs by services provided among all support departments. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 10

Allocating Support Departments Costs The Canton Division of Smith Corporation has two operating departments and two support departments. Assembly and Finishing Maintenance and Human Resources © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 11

Allocating Support Departments Costs Total square feet = 255, 000 Total number of employees = 95 Maintenance is allocated using square feet. Human Resources is allocated using number of employees. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 12

Allocating Support Departments Costs Maintenance Budgeted costs before allocations: $300, 000 Square feet: 5, 000 Number of employees: 8 Human Resources $2, 160, 000 30, 000 15 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 13

Allocating Support Departments Costs Assembly Budgeted costs before allocations: $1, 700, 000 Square feet: 110, 000 Number of employees: 48 Finishing $900, 000 110, 000 24 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 14

Direct Method Support Departments Maintenance $300, 000 0% 0% Human Resources $2, 160, 000 Operating Departments $1, 700, 000 Assembly 110/220 110 2 7 / 8 4 /220 24/72 $900, 000 Finishing © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 15

Direct Method Support Departments Maintenance $300, 000 Operating Departments 0% 0% Human Resources $2, 160, 000 $1, 700, 000 Assembly $150, 000 4 4 , 1 $ 0 0 0 , 0 $15 0, 00 $720, 000 0 $900, 000 Finishing © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 16

Direct Method Original costs: Maintenance Allocated: Human Resources Allocated: Total Assembly $1, 700, 000 150, 000 Finishing $ 900, 000 150, 000 1, 440, 000 $3, 290, 000 720, 000 $1, 770, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 17

Step-Down Method Which support department should be allocated first? Maintenance provides 12% of its services to Human Resources provides 10% of its services to Maintenance to Human Resources: 30, 000 ÷ 250, 000 (or 12%) × $300, 000 = $36, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 18

Step-Down Method Maintenance to Assembly: 110, 000 ÷ 250, 000 (or 44%) × $300, 000 = $132, 000 Maintenance to Finishing: 110, 000 ÷ 250, 000 (or 44%) × $300, 000 = $132, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 19

Step-Down Method Maintenance: Human Resources: Assembly: Finishing: Costs before allocation $ 300, 000 $2, 160, 000 $1, 700, 000 $ 900, 000 Allocated costs ($300, 000) $ 36, 000 $132, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 20

Step-Down Method Human Resources costs to be allocated become $2, 160, 000 + $36, 000 = $2, 196, 000. Human Resources to Assembly: 48 ÷ 72 × $2, 196, 000 = $1, 464, 000 Human Resources to Finishing: 24 ÷ 72 × $2, 196, 000 = $732, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 21

Step-Down Method Human Resources: Assembly: Finishing: Costs before Allocated allocation costs Allocated costs $2, 160, 000 $1, 700, 000 $ 900, 000 ($2, 196, 000) $ 1, 464, 000 $ 732, 000 $ 36, 000 $132, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 22

Step-Down Method Total cost after allocation: Assembly Department: $1, 700, 000 + $132, 000 + $1, 464, 000 = $3, 296, 000 Finishing Department: $900, 000 + $132, 000 + $732, 000 = $1, 764, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 23

Reciprocal M HR A F Maintenance – 12% 44% Human Resources 10% – 60% 30% Maintenance cost = $300, 000 +. 10 P Human Resource cost = $2, 160, 000 +. 12 M © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 24

Reciprocal Maintenance cost (M) = $300, 000 +. 10($2, 160, 000 +. 12 M) M = $300, 000 + $216, 000 +. 012 M. 988 M = $516, 000 M = $522, 267 HR = $2, 160, 000 +. 12($522, 267) HR = $2, 160, 000 + $62, 672 = $2, 222, 672 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 25

Reciprocal M Before allocation: Allocation: Total HR A $300, 000 $2, 160, 000 $1, 700, 000 (522, 267) 62, 672 229, 797 222, 267 ($2, 222, 672) 1, 333, 603 $3, 263, 400 F $ 900, 000 229, 797 666, 802 $1, 796, 599 Total cost Assembly Department: $3, 263, 400 Total cost Finishing Department: $1, 796, 599 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 26

Overview of Methods Overhead rate for the Assembly Department is determined using direct labor cost as a denominator. Overhead rate for the Finishing Department is determined using machine-hours as the denominator. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 27

Comparison of Methods Assembly Finishing Direct labor cost: $698, 880 $349, 440 Machine-hours: 24, 000 23, 500 What are the various overhead rates using the three methods? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 28

Overhead Rates Direct Method Assembly: $3, 290, 000 ÷ $698, 880 direct labor costs = 471% of direct labor costs Finishing: $1, 770, 000 ÷ 23, 500 = $75. 32 per machine-hour © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 29

Overhead Rates Step-Down Method Assembly: $3, 296, 000 ÷ $698, 880 direct labor costs = 472% of direct labor cost Finishing: $1, 764, 000 ÷ 23, 500 = $75. 06 per machine-hour © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 30

Overhead Rates Reciprocal Assembly: $3, 263, 400 ÷ $698, 880 direct labor costs = 467% of direct labor cost Finishing: $1, 796, 599 ÷ 23, 500 = $76. 45 per machine-hour © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 31

Comparison of Rates Direct method: Step-down method: Reciprocal method: Assembly Finishing 471% $75. 32 472% $75. 06 467% $76. 45 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 32

Learning Objective 4 Allocate common costs using either the stand-alone or incremental method. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 33

Allocating Common Costs Two methods for allocating common cost are: 1. Stand-alone cost allocation method 2. Incremental cost allocation method © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 34

Stand-Alone Example A consultant in Tampa is planning to go to Chicago and meet with an international client. The round-trip Tampa/Chicago/Tampa airfare costs $540. The consultant is also planning to attend a business meeting with a North Carolina client in Durham. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 35

Stand-Alone Example The round-trip Tampa/Durham/Tampa airfare costs $360. The consultant decides to combine the two trips into a Tampa/Durham/Chicago/Tampa itinerary that will cost $760. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 36

Stand-Alone Example How much should the consultant charge to the North Carolina client? $360 ÷ ($360 + $540) =. 40 × $760 = $304 How much to the international client? $760 – $304 = $456 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 37

Incremental Cost Example Assume that the business meeting in Chicago is viewed as the primary party. What would be the cost allocation? International client (primary) $540 Durham client (incremental) $760 – $540 = $220 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 38

Learning Objective 5 Explain the importance of explicit agreement between contracting parties when reimbursement is based on costs incurred. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 39

Cost Allocation and Contracts Many commercial contracts include clauses that require the use of cost accounting information. Contract disputes arise with some regularity, often with respect to cost allocation. Cost assignment rules should be as explicit as possible (and in writing). © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 40

Learning Objective 6 Understand how bundling of products gives rise to revenue-allocation issues. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 41

Revenues and Bundled Products A bundled product is a package of two or more products (or services) sold for a single price. Bundled product sales are also referred to as “suite sales. ” The individual components of the bundle also may be sold as separate items at their own “stand-alone” prices. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 42

Revenues and Bundled Products What businesses provide bundled products? Banks Checking § Safety deposit boxes § Investment advisory § Hotels Lodging § Food and beverage services § Recreation § Tours Transportation § Lodging § Guides § © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 43

Learning Objective 7 Allocate the revenues of a bundled package to the individual products in that package. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 44

Revenue Allocation Methods English Languages Institute buys English language software programs locally and then sells them in Mexico and Central America. English sells the following programs: Grammar, Translation, and Composition These programs are offered stand-alone or in a bundle. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 45

Revenue Allocation Methods Stand-alone Grammar Translation Composition Price $255 $ 85 $185 Purchasing these software programs costs English the following: Grammar $180 Translation $ 45 Composition $ 95 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 46

Revenue Allocation Methods Bundle (Suites) Grammar + Translation Grammar + Composition Grammar + Translation + Composition © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Price $290 $350 $410 15 - 47

Revenue Allocation Methods The two main revenue allocation methods are: 1. The stand-alone method 2. The incremental method © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 48

Stand-Alone Revenue Allocation Method There are four types of weights for the stand-alone revenue allocation method. 1. Selling prices 2. Unit costs 3. Physical units 4. Stand-alone product revenues © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 49

Stand-Alone Revenue Allocation Method Consider the Grammar and Translation suite, which sells for $290 per day. How much weight should English Languages Institute assign to each item? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 50

Stand-Alone Revenue Allocation Method Selling prices: The individual selling prices are $255 for Grammar and $85 for Translation. Grammar: $255 ÷ $340 = 0. 75, $290 × 0. 75 = $217. 50 Translation: $85 ÷ $340 = 0. 25, $290 × 0. 25 = $72. 50 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 51

Stand-Alone Revenue Allocation Method Unit costs: This method uses the costs of the individual products to determine the weights for the revenue allocations. Grammar: $180 ÷ $225 = 0. 80, $290 × 0. 80 = $232 Translation: $45 ÷ $225 = 0. 20, $290 × 0. 20 = $58 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 52

Stand-Alone Revenue Allocation Method Physical units: This method gives each product unit in the suite the same weight when allocating suite revenue to individual products. With two products in the suite, each product is allocated 50% of suite revenues. 1 ÷ (1 + 1) = 0. 50 $290 × 0. 50 = $145 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 53

Stand-Alone Revenue Allocation Method Stand-alone product revenues: This method captures the quantity of each product sold as well as their selling prices. Assume that the stand-alone revenues in 2003 are Grammar $734, 400, Translation $81, 600, and Composition $133, 200. What are the weights for the Grammar and Translation suite? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 54

Stand-Alone Revenue Allocation Method Grammar: $734, 400 ÷ $816, 000 = 0. 90, $290 × 0. 90 = $261 Translation: $81, 600 ÷ $816, 000 = 0. 10, $290 × 0. 10 = $29 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 55

Stand-Alone Revenue Allocation Method Revenue Allocation Weights Grammar Translation Selling prices $217. 50 $ 72. 50 Unit costs 232. 00 58. 00 Physical units 145. 00 Stand-alone product revenues 261. 00 29. 00 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 56

Incremental Revenue Allocation Method The first-ranked product is termed the primary product in the bundle. The second-ranked product is termed the first incremental product. The third-ranked product is the second incremental product, and so on. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 57

Incremental Revenue Allocation Method Assume that Grammar is designated as the primary product. If the suite selling price exceeds the standalone price of the primary product, the primary product is allocated 100% of its stand-alone revenue. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 58

Incremental Revenue Allocation Method Grammar and Translation suite selling price = $290 per day Allocated to Grammar: $255 Remaining to be allocated: ($290 – $255) = $35 Allocated to Translation: $35 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 59

End of Chapter 15 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 15 - 60