Question

Why is allocation of support departments and joint costs so important? What are the most common methods of allocating these costs?

Answer 1

Mutually beneficial costs, which occur when the same resource is used in the output of two or more services or products, are known as common costs. These common costs may pertain to periods of time, individual responsibilities, sales territories, and classes of customers. A special case of common costs is that of the joint production process. This chapter will first focus on the costs common to departments and to products, and then on the common costs of the joint production process.

The complexity of many modern firms leads the accountant to allocate costs of support departments to producing departments and individual product lines. Allocation is simply a means of dividing a pool of 7 C HAP TE R © DIGITAL VISION/GETTY IMAGES costs and assigning those costs to various subunits. It is important to realize that allocation does not affect the total cost. Total cost is neither reduced nor increased by allocation. However, the amounts of cost assigned to the subunits can be affected by the allocation procedure chosen. Because cost allocation can affect bid prices, the profitability of individual products, and the behavior of managers, it is an important topic. For example, the wages paid to security guards at a factory are a common cost of all of the different products manufactured there. The benefits of security are applicable to each product, yet the assignment of security cost to the individual products is an arbitrary process. In other words, while it is clear that the products (or services) require the common resource and that the resource cost should be assigned to these cost objects, it is often not clear how best to go about assigning the cost. Usually, common cost assignment is made through a series of consistent allocation procedures. Types of Departments The first step in cost allocation is to determine just what the cost objects are. Usually, they are departments. There are two categories of departments: producing departments and support departments. Producing departments are directly responsible for creating the products or services sold to customers. In a large public accounting firm, examples of producing departments are auditing, tax, and management advisory services (computer systems services). In a manufacturing setting such as Volkswagen (VW), producing departments are those that work directly on the products being manufactured (e.g., assembly and painting). Support departments provide essential services for producing departments. These departments are indirectly connected with an organization’s services or products. At VW, those departments might include engineering, maintenance, personnel, and building and grounds. Once the producing and support departments have been identified, the overhead costs incurred by each department can be determined. Note that this involves tracing costs to the departments, not allocating costs, because the costs are directly associated with the individual department. A factory cafeteria, for example, would have food costs, wages of cooks and servers, depreciation on dishwashers and stoves, and supplies (e.g., napkins and plastic forks). Overhead directly associated with a producing department such as assembly in a furniture-making plant would include utilities (if measured in that department), supervisory salaries, and depreciation on equipment used in that department. Overhead that cannot be easily assigned to a producing or support department is assigned to a catchall department such as general factory. General factory might include depreciation on the factory building, rental of a Santa Claus suit for the factory Christmas party, the cost of restriping the parking lot, the plant manager’s salary, and telephone service. In this way, all costs are assigned to a department.

Frequently, the costs of a support department are allocated to another department through the use of a charging rate. In this case, we focus on the allocation of one department’s costs to other departments.

A Single Charging Rate Some companies prefer to develop a single charging rate. Suppose, for example, that Hamish and Barton, a large regional public accounting firm, develops an in-house photocopying department to serve its three producing departments (audit, tax, and management advisory systems, or MAS).

Dual Charging Rates While the use of a single rate is simple, it ignores the differential impact of changes in usage on costs. The variable costs of a support department increase as the level of service increases. For example, the costs of paper and toner for the photocopying department increase as the number of pages copied increases. Fixed costs, on the other hand, do not vary with the level of service

We can avoid the treatment of fixed costs as variable by developing two rates: one for fixed costs and one for variable costs. The development of dual charging rates (which are used as the basis for pricing) is particularly important in companies such as public utilities.

Developing a Fixed Rate Fixed service costs can be considered capacity costs; they are incurred to provide the capacity necessary to deliver the service units required by the producing departments. When the support department was established, its delivery capability was designed to serve the long-term needs of the producing departments. Since the original support needs caused the creation of the support service capacity, it seems reasonable to allocate fixed costs based on those needs. Either the normal or peak activity of the producing departments provides a reasonable measure of original support service needs. Normal capacity is the average capacity achieved over more than one fiscal period. If service is required uniformly over the time period, normal capacity is a good measure of activity. Peak capacity allows for variation in the need for the support department, and the size of the department is structured to allow for maximum need. In our example, the tax department may need much more photocopying during the first four months of the year, and its usage may be based on that need. The choice of normal or peak capacity in allocating budgeted fixed service costs depends on the needs of the individual firm. Budgeted fixed costs are allocated in this way regardless of whether the purpose is product costing or performance evaluation.

The allocation of fixed costs follows a 3-step procedure: 1. Determination of budgeted fixed support service costs. The fixed support service costs that should be incurred for a period need to be identified. 2. Computation of the allocation ratio. Using the practical or normal capacity of each producing department, it is necessary to compute an allocation ratio. The allocation ratio simply gives a producing department’s share or percentage of the total capacity of all producing departments. Allocation ratio Producing department capacity/Total capacity 3. Allocation. The fixed support service costs are then allocated in proportion to each producing department’s original support service needs. Allocation Allocation ratio Budgeted fixed support service costs

Developing a Variable Rate The variable rate depends on the costs that change as the activity driver changes. In the photocopying department, the activity driver is the number of pages copied. As the number of pages increases, more paper and toner are used.

Total Allocation Under the dual charging rates, the fixed photocopying rates are charged to the departments in accordance with their original capacity needs. Especially in a case like this one, in which fixed costs are such a high proportion of total costs, the additional effort needed to develop the dual rates may be worthwhile. The dual-rate method has the benefit of sending the correct signal regarding increased usage of the support department. Suppose that the tax department wants to have several research articles on tax law changes photocopied for clients. Should this be 284 Part 2 Fundamental Costing and Control done “in house” by the photocopying department or sent to a private photocopying firm that charges $0.06 per page? Under the single-rate method, the in-house cost charged would be too high because it wrongly assumes that fixed cost will increase as pages copied increase. However, under the dual-rate method, the additional cost would be only $0.023 per page, which correctly approximates the additional cost of the job.

Budgeted versus Actual Usage The second factor to be considered in charging costs from a single service department to other departments is whether actual usage or budgeted usage should be the basis for allocating costs. In truth, this factor only has an impact on allocated costs when fixed costs are involved. As a result, we need to consider it in the case of a single charging rate (which combines fixed with variable costs to generate a rate) and of the fixed portion of the dual charging rate. When we allocate support department costs to the producing departments, should we allocate actual or budgeted costs? The answer is budgeted costs. There are two basic reasons for allocating support department costs. One reason is to cost the units produced. In this case, the budgeted support department costs are allocated to producing departments as a preliminary step in forming the overhead rate. Recall that the overhead rate is calculated at the beginning of the period, when actual costs are unknown. Thus, budgeted costs must be used. The second usage of allocated support department costs is for performance evaluation. In this case, too, budgeted support department costs are allocated to producing departments. Managers of support and producing departments usually are held accountable for the performance of their departments. Their ability to control costs is an important factor in their performance evaluations. This ability is usually measured by comparing actual costs with planned or budgeted costs. If actual costs exceed budgeted costs, the department may be operating inefficiently, with the difference between the two costs serving as the measure of that inefficiency. Similarly, if actual costs are less than budgeted costs, the department may be operating efficiently.

Fixed versus Variable Bases: A Note of Caution Using normal or practical capacity to allocate fixed support service costs provides a fixed base. As long as the capacities of the producing departments remain at the level originally anticipated, there is no reason to change the allocation ratios. Thus, each year, the audit department receives 35 percent of the budgeted fixed photocopying costs, the tax department 25 percent, and the MAS department 40 percent, no matter what their actual usage is. If the capacities of the departments change, the ratios should be recalculated. In practice, some companies choose to allocate fixed costs in proportion to actual usage or expected actual usage. Since usage may vary from year to year, allocation of fixed costs would then use a variable base. Variable bases, however, have a significant drawback: they allow the actions of one department to affect the amount of cost allocated to another department

Choosing a Support Department Cost Allocation Method So far, we have considered cost allocation from a single support department to several producing departments. We used the direct method of support department cost allocation, in which support department costs are allocated only to producing departments. This was appropriate in the earlier example because no other support departments existed. This would also be appropriate when there is no possibility of interaction among support departments. Many companies do have multiple support departments, and they frequently interact. For example, in a factory, personnel and cafeteria serve each other, other support departments, and the producing departments. Ignoring these interactions and allocating support costs directly to producing departments may produce unfair and inaccurate cost assignments. For example, power, although a support department, may use 30 percent of the services of the maintenance department. The maintenance costs caused by the power department belong to the power department. By not assigning these costs to the power department, its costs are understated. In effect, some of the costs caused by power are “hidden” in the maintenance department because maintenance costs would be lower if the power department did not exist. As a result, a producing department that is a heavy user of power and an average or below-average user of maintenance may then receive, under the direct method, a cost allocation that is understated.

Direct Method of Allocation When companies allocate support department costs only to the producing departments, they are using the direct method of allocation. The direct method is the simplest and most straightforward way to allocate support department costs. Variable service costs are allocated directly to producing departments in proportion to each department’s usage of the service. Fixed costs are also allocated directly to the producing department, but in proportion to the producing department’s normal or practical capacity.

Sequential Method of Allocation The sequential (or step) method of allocation recognizes that interactions among the support departments do occur. However, the sequential method does not fully recognize support department interaction. Cost allocations are performed in step-down fashion, following a predetermined ranking procedure. This ranking can be performed in various ways. For example, a company could rank the support departments in order of the percentage of service they render to other support departments.

Reciprocal Method of Allocation The reciprocal method of allocation recognizes all interactions of support departments. Under the reciprocal method, the usage of one support department by another is used to determine the total cost of each support department, where the total cost reflects interactions among the support departments. Then, the new total of support department costs is allocated to the producing departments. This method fully accounts for support department interaction.