Question

Cooper Ltd. has 2 operating divisions: domestic sales and international sales.  They also have 2 support divisions: accounting support and human resources support. For the past year, Cooper’s cost records show the following information:

	Support Divisions		Operating Divisions
	Account’g Support	Human Resources Support	Domestic Sales	Inter-national Sales	Total
Budgeted costs incurred before any interdivision cost allocations	$500,000	$600,000	$8,400,000	$7,500,000	$ 17,000,000
Support work supplied by Accounting (based on # of employees)		20%	40%	40%	100%
Support work supplied by Human Resources (based on # of staffing actions)	10%		60%	30%	100%

Required:

1. Allocate the 2 support divisions’ costs to the operating divisions using the Direct Method.
2. Allocate the 2 support divisions’ costs to the operating divisions using the Reciprocal Method.
3. Allocate the 2 support divisions’ costs to the operating divisions using the Step Down Method – Allocate Accounting Support first.
4. What method do you recommend and why?
5. Cooper Ltd. would like to share the services of a consultant with another company, Hofstadter Inc.  The consultant will work a total of 1,000 hours for both companies: 700 for Cooper and 300 hours for Hofstadter Inc.  The total cost of the contract will be $368,000.  If Cooper were to contract directly with the consultant for 700 hours, the cost would have been $350,000. If Hofstadter were to contract directly with the consultant, the contract would have cost them $ 150,000. How should the companies divide up the cost of the consultant?

Answer 1

Answer a) ------------------------- Direct Method -------------------------

Step 1: Calculation of Cost Allocation of Accounting Department

We have,
Total Cost of Accounting Department = $ 500,000
Cost of Accounting Department to Domestic Sales is 40% = $ 200,000
Cost of Accounting Department to International Sales is also 40% = $ 200,000

Therefore, the Total Cost of Accounting Department to Total of Operating Divisions (Domestic Sales + International Sales) = $ 400,000

Since, in the Direct Method contribution of one support department to another support department is completely ignored, we will skip to calculate the contribution of Accounting Department to Human Resources Support.

Hence, the ratio of cost of Accounting Department to Domestic Sales = 200,000 / 400,000 = 1/2 i.e. 1/2 x $500,000 = $ 250,000
And, the ratio of cost of Accounting Department to International Sales = 200,000 / 400,000 = 1/2 i.e. 1/2 x $500,000 = $ 250,000

Step 2: Calculation of Cost Allocation of Human Resources Support

We have,

Total Cost of Human Resources Support = $ 600,000
Cost of Human Resources Support to Domestic Sales is 60% = $ 360,000
Cost of Human Resources Support to International Sales is also 40% = $ 180,000

Therefore, the Total Cost of Human Resources Support to Total of Operating Divisions (Domestic Sales + International Sales) = $ 540,000

Since, in the Direct Method contribution of one support department to another support department is completely ignored, we will skip to calculate the contribution of Human Resources Support to Accounting Department.

Hence, the ratio of cost of Human Resources Support to Domestic Sales = 360,000 / 540,000 = 0.667 = $ 600,000 x .667 = $ 400,000
And, the ratio of cost of Human Resources Support to International Sales = 180,000 / 540,000 = 0.333 = $ 600,000 x .333 = $ 200,000

Step 3: Tabulating the values calculated

So, as per the Direct Method the costs allocated table will be:

	Domestic Sales	International Sales
Accounting Department	$ 250,000	$ 250,000
Human Resources Support	$ 400,000	$ 200,000

Answer b) -----------------------------------------Reciprocal Method------------------------------------------------

Let Accounting Department = A and Human Resources Support = H

Now, A i.e. cost of Accounting Department = $ 500,000 + 20% of H
=> A = 500000 + (0.2 x H)

And, H i.e. cost of Human Resources Support = $ 600,000 + 10% of A
=> H = 600000 + (0.1 x A)

Starting from A = 500000 + 0.2 x H
= 500000 + 0.2 x (600000+ 0.1 x A)
= 500000 + 120000 + 0.02A
=> A = 734,693.88

Since, we have solved for A, our value of
H = 600000 + (0.1 x A) = 600000 + (01. x 734, 693.88) = 600000 + 73469.39
=>H = 673,469.39

Again, A = 734,693.88
& H = 673,469.39

Step 1: Calculation of allocation of cost of Accounting Department:

	Human Resources Department	Domestic Sales	International Sales
Ratio of Distribution of A	20%	40%	40%
Amount based on calculated A above	$ 146,938.78	$ 293,877.55	$ 293,877.55

Step 2: Calculation of allocation of cost of Human Resources Support:

	Accounting Department	Domestic Sales	International Sales
Ration of Distribution of H	10%	60%	30%
Amount based on calculated H	$ 69,346.94	$ 404,081.57	$ 202,040.88

Step 3: Final Cost Allocation to Operating Division will be

	Domestic Sales	International Sales
Accounting Department	$ 293,877.55	$ 293,877.55
Human Resources Support	$ 404,081.57	$ 202,040.88

Answer c)------------------------------------- Step Down Method-------------------------------------

We have been asked to start from Accounting Department so we start from there

Step 1: Accounting Department to Human Resources Support:
Total Accounting Department Cost = $ 500,000
Since 20% of Human Resources is used by Accounting Department, the cost to Human Resources will be 20% x $ 500,000
=> Accounting Department to Human Resources Support: $ 100,000

Step 2: Cost of Human Resources Support has changed

  It is now $ 600,000 + $ 100,000 = $ 700,000

Step 3: Cost allocation of Human Resources Support into Operating Divisions:

Cost of Human Resources Support to Domestic Sales = $ 700,000 x 6/9 = $ 466,667
Cost of Human Resources Support to Domestic Sales = $ 700,000 x 3/9 = $ 233,333

Step 4: Updated Cost Allocation Table for Operating Divisions:

	Domestic Sales	International Sales
Accounting Department	$ 200,000	$ 200,000
Human Resources Support	$ 466,667	$ 233,000

Answer d)------------------------- Which Method to Use-----------------------------

In my view we should Step Down Method since it is considered better practice all across. Since it does not ignore cost of any department like the direct method and it is simpler method than the reciprocal method.

It is also to note that the Step Down method is more widely acceptable methods.

Hence, I am for Step Down Method