Service Department Cost Allocation - Anna Lee

Service Department Cost Allocation
Explaining why service costs are allocated.
• Service Department:
Department that provides services
to other subunits in the organization.
• User Department:
Department that uses the functions
of service departments.
11 - 1

LO1
Service Department Cost Allocation
• Intermediate cost center:
Cost center whose costs are charged
to other departments in the organization.
• Final cost center:
Cost center, such as a production or
marketing department, whose costs
are not allocated to another cost center.
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LO1
Service Department Cost Allocation
Service and User Departments – Carlyle Coal Company
Service Department:
Information Systems
(S1)
Service Department:
Administration
(S2)
User Department:
Hilltop Mine
(P1)
User Department:
Pacific Mine
(P2)
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LO1
Service Department Cost Allocation
Basic Data for Service Department Cost Association
Carlyle Coal Company
Information
Systems (S1) a
Service Department
Administration
(S2) b
Departments:
Administration (S2)
Information Systems (S1)
Hilltop Mine (P1)
Pacific Mine (P2)
Total (to be distributed)
hours
100,000
-0-
20,000
80,000
200,000
50%
0
10
40
100%
employees)
-0-
2,000
5,000
3,000
10,000
0%
20
50
30
100%
a
Allocation base for S1: Computer hours; Cost to be allocated: $800,000
b
Allocation base for S2: Number of employees; Cost to be allocated: $5,000,000
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Cost Allocation: Direct Method
• Direct method:
Charges costs of service departments to user departments
without making allocations among service departments.
Service Department:
Information Systems
(S1)
Service Department:
Administration
(S2)
User Department:
Hilltop Mine
(P1)
User Department:
Pacific Mine
(P2)
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LO2
Cost Allocation: Direct Method
Service Department
Cost Allocation
Direct
Cost
Hilltop Mine
(P1)
Percent Applicable to
Pacific Mine
(P2)
Total
Service Department:
Information Systems (S1)
Administration (S2)
Service Department:
Information Systems (S1)
Administration (S2)
Total allocated
$ 800,000
5,000,000
Direct
Cost
$ 800,000
5,000,000
$5,800,000
Note: Under this method, S1 costs doesn’t allocate to S2.
20.0% a
62.5% b
Hilltop Mine
(P1)
$ 160,000 c
3,125,000 d
$3,285,000
a
20.0% = 20,000 hours ÷ (20,000 hours + 80,000 hours)
b
62.5% = 5,000 employees ÷ (5,000 employees + 3,000 employees)
c
$160,000 = 20% × $800,000
d
$3,125,000 = 62.5% × $5,000,000
80.0%
37.5%
Amount Applicable to
Pacific Mine
(P2)
$ 640,000
1,875,000
$2,515,000
100.0%
100.0%
Total
$ 800,000
5,000,000
$5,800,000
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Cost Allocation: Step Method
• The step method allocates some service
department costs to other service departments.
• Once an allocation is made from a service
department no further allocations are made
back to that service department.
• Generally, allocate in order of proportion of
services provided to other service departments.
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LO3
Cost Allocation: Step Method
Cost Flow Diagram: Step Method – Carlyle Coal Company
Service Department:
Information Systems
(S1)
Computerhours
User Department:
Hilltop Mine
(P1)
Service Department:
Administration
(S2)
Employees
User Department:
Pacific Mine
(P2)
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LO3
Cost Allocation: Step Method
Service Department Cost Allocation
Direct
Cost
(S1)
Percent Applicable to
(S2)
(P1)
(P2)
Total
Service Dept.:
(S1)
(S2)
$ 800,000
5,000,000
0.0%
0.0%
50.0% a
0.0%
10.0% b
62.5% d
40.0% c
37.5% e
100.0%
100.0%
a
50.0% = 100,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)
b
10.0% = 20,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)
c
40.0% = 80,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours
d
62.5% = 5,000 employees ÷ (5,000 employees + 3,000 employees)
e
37.5% = 3,000 employees ÷ (5,000 employees + 3,000 employees)
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LO3
Cost Allocation: Step Method
Service Department Cost Allocation
To
From
(S1)
(S2)
(P1)
(P2)
Total
Dept. costs
(S1)
(S2)
$800,000
(800,000)
-0-
$ -0-
$5,000,000
400,000 f
(5,400,000)
$ -0-
Note: Under Step method, S1 costs does allocate to S2
.
f
50.0% × $800,000
g
10.0% × $800,000
h
40.0% × $800,000
I
62.5% × $5,400,000
j
37.5% × $5,400,000
k
$5,800,000 of service department costs were
ultimately allocated to production departments.
$ -0-
80,000 g
3,375,000 i
$3,455,000
$ -0-
320,000 h
2,025,000 j
$2,345,000
$5,800,000 k
$5,800,000 k
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Cost Allocation: Reciprocal Method
• The reciprocal method recognizes all services
provided by any service department, including
services provided to other service departments.
• It accounts for cost flows among service
departments providing services to each other.
• It requires a simultaneous equation solution.
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LO4
Cost Allocation: Reciprocal Method
Cost Flow Diagram: Reciprocal Method – Carlyle Coal Company
Service Department:
Information Systems
(S1)
Computerhours
User Department:
Hilltop Mine
(P1)
Service Department:
Administration
(S2)
Employees
User Department:
Pacific Mine
(P2)
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LO4
Cost Allocation: Reciprocal Method
1. Write the costs of each service department
in equation form.
Total Service
Department costs
Direct costs of the
= +
Service Department
Costs allocated to the
Service Department
2. Solve equations simultaneously using
matrix algebra.
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LO4
Cost Allocation: Reciprocal Method
Total Service
Department costs
Direct cost of the
= +
Service Department
Costs allocated to the
Service Department
S1 = $ 800,000 + 0.20 S2
S2 = $5,000,000 + 0.50 S1
Substituting the first equation into the second yields:
S2 = $5,000,000 + 0.50($800,000 + 0.20 S2)
S2 = $5,000,000 + $400,000 + 0.10 S2
0.9 S2 = $5,400,000 S2 = $6,000,000
Substituting the value of S2 back into the first equation gives:
S1 = $800,000 + 0.20($6,000,000)
S1 = $2,000,000
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LO4
Cost Allocation: Reciprocal Method
Service Department Cost Allocation
Total
Cost
(S1)
Percent Applicable to
(S2)
(P1)
(P2)
Total
Service Dept.:
(S1)
(S2)
$2,000,000
6,000,000
0.0%
20.0% d
50.0% a
0.0%
10.0% b
50.0% e
40.0% c
30.0% f
100.0%
100.0%
a
50.0% = 100,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)
b
10.0% = 20,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours)
c
40.0% = 80,000 hours ÷ (100,000 hours + 20,000 hours + 80,000 hours
d
20.0% = 2,000 employees ÷ (2,000 employees + 5,000 employees + 3,000 employees)
e
50.0% = 5,000 employees ÷ (2,000 employees + 5,000 employees + 3,000 employees)
f
30.0% = 3,000 employees ÷ (2,000 employees + 5,000 employees + 3,000 employees
11 - 15

LO4
Cost Allocation: Reciprocal Method
Service Department Cost Allocation
To
From
(S1)
(S2)
(P1)
(P2)
Total
Direct costs
(S1)
(S2)
$ 800,000
(2,000,000) a
1,200,000 e
$ -0-
$5,000,000
1,000,000 b
(6,000,000) f
$ -0-
$ -0-
200,000 c
3,000,000 g
$3,200,000
$ -0-
800,000 d
1,800,000 h
$2,600,000
$5,800,000 i
$5,800,000 i
a
Total costs of S1
b
Costs allocated from S1 (50% × $2,000,000)
c
10.0% × $2,000,000
d
40.0% × $2,000,000
e
Costs allocated from S2 (20% × $6,000,000)
f
Total costs of S2
g
50% × $6,000,000
h
30% × $6,000,000
I
$5,800,000 of service department costs were ultimately
allocated to production departments.
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LO4
Cost Allocation: Reciprocal Method
Comparison of Direct, Step, and Reciprocal Methods
Method Hilltop Mine Pacific Mine Total
Direct
Step
Reciprocal
$3,285,000
3,455,000
3,200,000
$2,515,000
2,345,000
2,600,000
$5,800,000
5,800,000
5,800,000
11 - 17

The Reciprocal Method
and Decision Making
L.O. 5 Use the reciprocal method for decisions.
• Suppose that the variable cost in Information Services (S1)
is $200,000 (out of the total of $800,000) and the variable
cost in Administration (S2) is $3,500,000 (out of $5,000,000).
• Let's repeat the reciprocal cost analysis substituting
the variable costs from the total costs.
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LO5
The Reciprocal Method
and Decision Making
Total Service
Department costs
Direct cost of the
= +
Service Department
Costs allocated to the
Service Department
S1 = $ 200,000 + 0.20 S2
S2 = $3,500,000 + 0.50 S1
Substituting the first equation into the second yields:
S2 = $3,500,000 + 0.50($200,000 + 0.20 S2)
S2 = $3,500,000 + $100,000 + 0.10 S2
0.9 S2 = $3,600,000 S2 = $4,000,000
Substituting the value of S2 back into the first equation gives:
S1 = $200,000 + 0.20($4,000,000)
S1 = $1,000,000
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The Reciprocal Method
and Decision Making
• The total variable cost of Information Services, when you
consider the use of Administration by Information Services
is $1,000,000.
• The total cost savings that would come from eliminating
Information Services are the $1,000,000 variable costs
plus any avoidable fixed costs.
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Allocation of Joint Costs
Joint cost is the cost of a manufacturing process with two or more
outputs produced together up to a split-off point.
Split-off
point
Hi-grade coal: 15,000 units
Sales value: $300,000
Mining costs
$270,000
(Joint Costs)
Lo-grade coal: 30,000 units
Sales value: $450,000
(Separable Costs)
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Allocation of Joint Costs
2 Methods of Allocation:
Net realizable value method
Physical quantities method
• Net realizable value method:
Joint cost allocation based on the proportional
values of the products at the split-off point.
• Net realizable value (NRV):
Sales value of each product at the split-off point.
• Estimated net realizable value:
If the sales value at split-off is not available, use the
estimated NRV method. That is sales price of a final product
minus additional processing costs necessary to prepare
a product for sale.
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Net Realizable Value Method
Final sales value
Less: Additional processing costs
Net realizable value at split-off point
Proportionate share:
= $300,000 ÷ $750,000
= $450,000 ÷ $750,000
Allocated joint costs:
= $270,000 × 40%
= $270,000 × 60%
Example
Carlyle Coal Company
Joint Allocation – NRV Method
(no additional processing costs)
Hi-Grade Lo-Grade Total
$300,000
-0-
$300,000
40%
$108,000
$450,000
-0-
$450,000
60%
$162,000
$750,000
-0-
$750,000
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Net Realizable Value Method
Carlyle Coal Company
For the Month of March
Sales value
Less: Allocated joint costs
Gross margin
Gross margin as a percent of sales
Hi-Grade Lo-Grade Total
$300,000
108,000
$192,000
64%
$450,000
162,000
$288,000
64%
$750,000
270,000
$480,000
64%
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Estimating NRV
• When no sales value exists for outputs at the split-off point,
the estimated NRV should be determined.
Further Processing of Coal:
Cost Flows –
Carlyle Coal Company
Split-off
point
Hi-grade coal: 15,000 units
Sales value: $300,000
Mining costs
$270,000
Lo- to Mid-grade coal:
30,000 units
$50,000 processing cost
Sales value: $550,000
11 - 25

Estimating NRV
Carlyle Coal Company
For the Month of March
Sales value
Less: Additional cost to process
Estimated NRV at split-off
Allocation of joint costs
Gross margin
Gross margin as a percent of sales
Hi-Grade Mid-Grade Total
$300,000 $550,000
to mid-grade — coal 50,000
$300,000 $500,000
101,250 a —
— 168,750 b
$198,750 $331,250
66% 60%
$850,000
50,000
$800,000
101,250
168,750
$530,000
62%
a
($300,000 ÷ $800,000) × $270,000
b
($500,000 ÷ $800,000) × $270,000
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Physical Quantities Method
• Joint cost allocation is based on measurement of
the volume, weight, or other physical measure of
the joint products at the split-off point.
When to use:
1. Output product prices are volatile.
2. Significant processing occurs between the
split-off point and the first point of marketability.
3. Product prices are not set by the market.
11 - 27

Physical Quantities Method
Carlyle Coal Company
For the Month of March
Quantity (tons)
Sales value
Allocation of joint costs
Gross margin
Gross margin as a percent of sales
Hi-Grade Lo-Grade Total
15,000
$300,000
90,000 a
$210,000
70%
30,000
$450,000
180,000 b
$270,000
60%
45,000
$750,000
270,000
$480,000
64%
a
(15,000 tons ÷ 45,000 tons) × $270,000
b
(30,000 tons ÷ 45,000 tons) × $270,000
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By-products
• By-products are outputs of joint production processes
that are relatively minor in quantity or value. Joint costs
are usually not allocated to a by-product, instead,
market value of by-product is reported as follows:
• Method 1:
The net realizable value from sale of the by-products
is deducted from the joint costs (as a contra production
cost) before allocation to the main products.
• Method 2:
The proceeds from sale of the by-product are treated
as other revenue (other income).
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By-products – Method 1
Carlyle Coal Company
For the Month of March
Hi-Grade
Lo-Grade
Dust
by-product
Total
Sales value
Less: Additional processing costs
Net realizable value at split-off point
Deduct: Sales value of by-product a
Allocated remaining joint costs a
Gross margin
Gross margin as a percent of sales
$300,000
-0-
$300,000
-0-
102,000 b
$198,000
66%
$450,000
-0-
$450,000
-0-
153,000 c
$297,000
66%
$15,000
-0-
$15,000
15,000
-0-
-0-
0%
$765,000
-0-
$765,000
15,000
255,000
$495,000
65%
a Note: Joint costs adjusted for sales value of by-product (dust) (765,000 – 15,000 = 750,000)
b
($300,000 ÷ $750,000) or 40% × ($270,000 Joint cost – $15,000)
c
($450,000 ÷ $750,000) or 60% × ($270,000 – $15,000)
11 - 30

Carlyle Coal Company
For the Month of March
Quantity (tons)
Sales value
Allocation of joint costs
Gross margin
Gross margin as a percent of sales
15,000
$300,000
108,000
$192,000
64%
30,000
$450,000
162,000
$288,000
64%
45,000
$750,000
270,000
$480,000
64%
(300,000÷ 750,000) = 40% 270,000 x 40% = 108,000
(450,000÷ 750,000) = 60% 270,000 x 60% = 162,000

By-products – Method 2
Carlyle Coal Company
For the Month of March
Hi-Grade
Lo-Grade
Dust
Total
Sales value
Less: Additional processing costs
Net realizable value at split-off point
Allocated joint costs a
Gross margin
Gross margin as a percent of sales
$300,000
-0-
$300,000
108,000 b
$192,000
64%
$450,000
-0-
$450,000
162,000 c
$288,000
64%
$15,000
-0-
$15,000
-0-
$15,000
100%
$765,000
-0-
$765,000
270,000
$495,000
65%
a
Joint costs adjusted for sales value of by-product (dust)
b
($300,000 ÷ $750,000) or 40% × $270,000 joint cost = 108,000. 15,000 is not deducted
from joint cost, instead, it is reported as other income.
c
($450,000 ÷ $750,000) or 60% × $270,000 = 162,000
11 - 32

Sell or Process Further
• Suppose CCC can sell Lo-grade coal for $450,000
at the split-off point or process it further to make
mid-grade coal.
• Mid-grade coal would sell for $550,000 and
additional processing costs would be $50,000.
Additional revenue: $100,000
?
Additional cost: $ 50,000
11 - 33

Sell or Process Further
Differential Analysis
Carlyle Coal Company
Sell
Lo-Grade
Coal
Process
Further
(Mid-Grade)
Differential
Revenue/
Costs
Revenues
Less: Separate processing costs
Margin
$450,000
-0-
$450,000
$550,000
50,000
$500,000
$100,000
50,000
$ 50,000
Net gain from
processing
further
11 - 34