Question

Ming Tai Manufacturing Company (Ming Tai) manufactures hydraulic machinery. The company has two services departments - the I.T. Department and the Purchasing Department. The departments are serving the two production departments in the company – the Machining Department and the Assembly Department. The work done in the I.T. Department is measured by the direct labour-hours of information technology support works. The work done in Purchasing Department is measured by the number of materials purchase order. The budgeted costs of the two service departments for 2020 are as follow:

	I.T. Department $	Purchasing Department $
Variable indirect labour and indirect materials costs	460,000	200,000
Salary of the department manager	180,000	100,000
Depreciation of machinery and equipment	200,000	60,000
Total	840,000	360,000

Depreciation of machinery and equipment is the straight-line depreciation in its 19th year of an estimated 25-year useful life. The distribution of each service department’s effort to the two production departments are as follow:

Used by

Served by	I.T. Department	Purchasing Department	Machining Department	Assembly Department
I.T. Department (Direct labour-hours)	0	800	2,000	1,200
Purchasing Department (Number of materials purchase order)	3,000	0	500	1,500

Required:

(a) Allocate the costs of the two services departments – I.T. and Purchasing, to the production departments – Machining and Assembly, using the following methods

i) the direct method;

ii) the step-down method (allocate I.T. Department first);

iii) the step-down method (allocate Purchasing Department first);

iv) the reciprocal method using linear equations.

(b) Ming Tai’s management has conducted a process reengineering study and discovered that all the works of the Purchasing Department could be outsourced. A third-party supply-chain service provider has offered to provide all the services of the present Purchasing Department for $35 per materials purchase order. If Ming Tai decides to outsource the services, all existing staff in the Purchasing Department will be transferred to other new positions in the company; and all the machine and equipment currently used in the Purchasing Department will be disposed with zero value. From a financial perspective only, should Ming Tai accept the offer? Explain.

Answer 1

Answer:

a).

(i) Allocation of costs of services department (under direct method):

Service Department	Basis	Machining Department	Assembly Department
I.T. Department (Working Note 1)	Direct labor hours	$525,000	$315,000
Purchasing department (Working note 2)	Number of materials purchase orders	$90,000	$270,000
Total		$615,000	$585,000

(ii) Allocation of costs of services department under step down method (allocating I.T. Department first):

Department	Basis	I.T. Department	Purchasing department	Machining Department	Assembly Department
Costs given in the budget		$840,000	$360,000
Allocation of costs of I.T. Department (Working note 3)	Direct labor hours	($840,000)	$168,000	$420,000	$252,000
		Nil	$528,000	$420,000	$252,000
Allocation of costs of Purchasing Department (Working note 4)	Number of materials purchase orders	Nil	($528,000)	$132,000	$396,000
Total		Nil	Nil	$552,000	$648,000

(iii) Allocation of costs of services department under step down method (allocating Purchasing Department first)

Department	Basis	I.T. Department	Purchasing department	Machining Department	Assembly Department
Costs given in the budget		$840,000	$360,000
Allocation of costs of Purchasing Department (Working note 5)	Number of materials purchase orders	$216,000	($360,000)	$36,000	$108,000
		$1,056,000	Nil	$36,000	$108,000
Allocation of costs of I.T. Department (Working note 6)	Direct labor hours	($1,056,000)	Nil	$660,000	$396,000
Total		Nil	Nil	$696,000	$504,000

(iv) Allocation of costs of services department under reciprocal method

Service department expenses as per budget:

I.T. Department = $840,000

Purchasing department = $360,000

Served by/ Served to	I.T. Department	Purchasing department	Machining department	Assembly department	Total
I.T. Department (Direct labor hours)	0	800	2,000	1,200	4,000
Percentage of Direct labor hours	0	20%	50%	30%	100%
Purchasing departments ( Number of materials purchase orders)	3000	0	500	1500	5000
Percentage of number of materials purchase orders	60%	0	10%	30%	100%

Percentage of costs of Purchasing Department used by I.T. Department= 3000/ 5000= 60%

Percentage of costs of I.T. Department used by Purchasing Department = 800 / 4000 = 20%

Let total expenses of I.T. Department = X

And let total expenses of Purchasing Department = Y

X = $840,000 + 60% of Y                        [ equation 1]

Y = $360,000 + 20% of X                        [ equation 2]

Now putting the value of Y = $360,000 + 20% of X in equation 1

X = $840,000 + 60% of Y  

X = $840,000 + 60% ($360,000 + 20% of X)

X = $840,000 + $216,000 +0.12X

X= $1,056,000 + 0.12X

X – 0.12 X = $1,056,000

0.88 X = $1,056,000

X = $1,056,000/ 0.88

X = $1,200,000

Now putting the value of X = $1,200,000 in equation 2

Y = $360,000 + 20% of X

Y = $360,000 + 20% of $1,200,000

Y = $360,000 + $240,000

Y = $600,000

Service Department	Basis	Machining Department	Assembly Department
I.T. Department (Working note 7)	Percentage of direct labor hours as per table given above	$600,000	$360,000
Purchasing department (Working note 8)	Percentage of number of materials purchase orders as per table given above	$60,000	$180,000
Total		$660,000	$540,000

b.

Costs related to Purchasing department as per budget = $360,000

Purchase cost as per new proposal = $35 per purchasing order

Total number of purchase orders = 3,000 + 500 + 1500 = 5,000 purchase orders

Cost of purchase orders under the new proposal = $35 x 5000 =$175,000

Ming Tai should accept the proposal to outsource the works of purchasing department as it is providing a saving of $185,000 to the company.

Working notes:

1. Allocation of costs of I.T. Department under direct method:

Direct labor hours of Machining department =2,000 hours

Direct labor hours of Assembly department =1,200 hours

Total costs of I.T. Department= $840,000

The costs of I.T. department are allocated on the basis of ratio of direct labor hours of the production departments.

Ratio of the direct labor hours in both the production departments = 2000 : 1200 = 5 : 3

Costs allocated to Machining department = $840,000 x 5/8 = $525,000

Costs allocated to Assembly department = $840,000 x 3/8 = $315,000

2. Allocation of costs of Purchasing department under direct method:

Purchase orders of Machining department =500 orders

Purchase orders of Assembly department =1,500 orders

Total expenses of Purchasing department = $360,000

The costs of purchasing department are allocated on the basis of ratio of number of purchasing orders of the production departments.

Ratio of the number of purchase orders in both the production departments = 500 : 1500 = 1 : 3

Costs allocated to Machining department = $360,000 x 1/4 = $90,000

Costs allocated to Assembly department = $360,000 x 3/4 = $270,000

3. Allocation of costs of I.T. Department under step-down method (I.T. Department allocated first):

Direct labor hours of Purchasing department = 800 hours

Direct labor hours of Machining department =2,000 hours

Direct labor hours of Assembly department =1,200 hours

Total expenses of I.T. Department= $840,000

The costs of I.T. department are allocated on the basis of ratio of direct labor hours of the one service and two production departments.

Ratio of the direct labor hours in the three departments = 800 : 2,000 : 1,200 = 2 : 5 : 3

Costs allocated to Purchasing department = $840,000 x 2/10 = $168,000

Costs allocated to Machining department = $840,000 x 5/10 = $420,000

Costs allocated to Assembly department = $840,000 x 3/10 = $252,000

4. Allocation of costs of Purchasing department under step down method (I.T. Department allocated first):

Costs of Purchasing department = $528,000

The costs of purchasing department are allocated on the basis of ratio of number of purchasing orders of the production departments.

Ratio of the number of purchase orders in both production departments (from working note 2) = 1 : 3

Costs allocated to Machining department = $528,000 x 1/4 = $132,000

Costs allocated to Assmebly department = $528,000 x 3/4 = $396,000

5. Allocation of costs of Purchasing department under step down method (Purchasing Department allocated first):

Purchase orders of I.T. department = 3,000 orders

Purchase orders of Machining department =500 orders

Purchase orders of Assembly department =1,500 orders

Total expenses of Purchasing department = $360,000

The costs of purchasing department are allocated on the basis of ratio of number of purchasing orders of one service and two production departments.

Ratio of the number of purchase orders in the three departments =3000 : 500 : 1500 = 6 : 1 :3

Costs allocated to I.T. department = $360,000 x 6/10 = $216,000

Costs allocated to Machining department = $360,000 x 1/10 = $36,000

Costs allocated to Assembly department = $360,000 x 3/10 = $108,000

6. Allocation of costs of I.T. Department under step down method (Purchasing Department allocated first):

Costs of I.T. department = $1,056,000

The costs of I.T. department are allocated on the basis of ratio of direct labor hours of the production departments.

Ratio of the direct labor hours in both production departments (from working note 1) = 5 : 3

Costs allocated to Machining department = $1,056,000 x 5/8 = $660,000

Costs allocated to Assembly department = $1,056,000 x 3/8 = $396,000

7. Allocation of costs of I.T. Department under reciprocal method:

Total costs of I.T. Department under reciprocal method = $1,200,000

Percentage of direct labor hours used by Machining department = 50%

Costs allocated to Machining department = $1,200,000 x 50% = $600,000

Percentage of direct labor hours used by Assembly department =30%

Costs allocated to Assembly department = $1,200,000 x 30% = $360,000

8. Allocation of costs of Purchasing Department under reciprocal method:

Total costs of Purchasing Department under reciprocal method = $600,000

Percentage of purchase orders of Machining department = 10%

Costs allocated to Machining department = $600,000 x 10% = $60,000

Percentage of purchase orders of Assembly department =30%

Costs allocated to Assembly department = $600,000 x 30% = $180,000