Question

Item18

Time Remaining 1 hour 53 minutes 45 seconds

01:53:45

Item 18

Item 18

Time Remaining 1 hour 53 minutes 45 seconds

01:53:45

At the beginning of this year, a group of lawyers and accountants in Calgary decided to join efforts in providing one-stop legal and accounting consulting services to industry and the government. The group established a consulting company, rented office space, and hired both professional and clerical staff.

      Following several initial organizational meetings, the partners decided to divide the operation into three parts: the Consulting Department, the Legal Department, and the Accounting Department.

     The consulting department deals directly with the clients, providing two somewhat distinct services, accounting consulting (AC) and legal consulting (LC). In its first full month of operations, this department recorded its own identifiable costs as $20,000, with 30% attributed to accounting consultations and 70% to legal work. Billings to clients amounted to $40,000 and $25,500 for accounting and legal consultations, respectively. This department made use of the other two departments’ services in preparing work for the external clients.

     The accounting and legal departments provided professional services for each other and for the consulting department on the basis of time according to the following schedule:

							Consulting
	Accounting Department			Legal Department			AC			LC
Departmental costs before allocation	$	10,000		$	15,000			?			?
Proportion of Accounting Department services used					20	%		60	%		20	%
Proportion of Legal Department services used		50	%					10	%		40	%

The accounting department incurred $10,000 in costs in the first month, and the legal department incurred $15,000. Neither department directly bills external clients.

     Having completed the first month’s activity, the partners are ready to evaluate the performance of the group and of the individual areas.

Required:
1.Prepare an income statement for each consulting branch using the direct allocation method.

2. Prepare an income statement for each consulting branch using the the step-down method.

3. Recommend one of the two methods to the partners and justify your choice.

• Direct allocation method

• Step-down method

Answer 1

	Accounting Dept	Legal Dept	Accounting Consultancy	Legal Consultancy
Deptt cost before allocation	10000	15000
Proportion of Account Dept service used	-	20%	60%	20%
Proportion of Legal Dept service used	50%	-	10%	40%
1. DIRECT ALLOCATION METHOD
Proportion of service used by AC & LC of accounts Deptt	60+20=80
Proportion of service used by AC & LC of legal Deptt		10+40=50
Allocation of accounts deptt cost in AC & LC in following ratio			60/80	20/80
Allocation of legal deptt cost in AC & LC in following ratio			10/50	40/50
	SERVICE DEPARTMENTS	OPERATING DEPARTMENTS
	Accounting Dept	Legal Dept	Accounting Consultancy	Legal Consultancy
REVENUE (A)			40000	25500
Identifiable costs
($20000 in ration of 3:7 in Accounts and Legal resp.)	10000	15000	6000	14000
Allocating cost of account deptt in AC & LC	-10000		7500	2500
Allocating cost of legal deptt in AC & LC		-15000	3000	12000
TOTAL COST (B)	0	0	16500	28500
NET INCOME (A-B)			23500	-3000
2. STEP DOWN METHOD: Under step-down allocation method, firstly cost of that service deptt is allocated which provides greatest amount of servicee to other service deptt. In the given example, legal deptt provides 50% of its service to accounts deptt. Hence cost of legal deptt will be allocated first to accounts deptt, AC & LC and the cost of accounts deptt will be allocated in AC & LC.
	Accounting Dept	Legal Dept	Accounting Consultancy	Legal Consultancy
Proportion of service of legal deptt used by accounts dept, AC & LC	50%		10%	40%
The proportion of service of accounts Deptt used by AC & LC			60%	20%
Allocation of legal dept cost in accounts dept, AC & LC in the following ratio	50/100		10/100	40/100
Allocation of accounts dept cost in AC & LC in following ratio			60/80	20/80
	SERVICE DEPARTMENTS	OPERATING DEPARTMENTS
	Accounting Dept	Legal Dept	Accounting Consultancy	Legal Consultancy
REVENUE (A)			40000	25500
Identifiable costs
($20000 in ration of 3:7 in Accounts and Legal resp.)	10000	15000	6000	14000
Allocating cost of legal deptt in accounts deptt, AC & LC	7500	-15000	1500	6000
Allocating cost of legal deptt in AC & LC	-17500		13125	4375
TOTAL COST (B)	0	0	20625	24375
NET INCOME (A-B)			19375	1125

3. As per my view, the step-down method is more recommendable as it allocates the cost of service department among other service departments to some extent based on the percentage of its services used by another service department starting with the cost allocation of that service department which provided its maximum service to other service department and then cost of another service department is then allocated among operating departments. This way, the cost of service departments is properly being allocated amongst other service dept and then to the operating dept.

While in the Direct method, the cost of the service dept is not allocated in another service dept even though the service is provided amongst each other. It direct allocates the cost of service dept to operating dept ignoring the fact that the cost of service dept also includes the cost for providing service to another service dept.