Chapter 5

Cost Allocation
(Allocating Costs of Support Departments)

Cost and Management Accounting I

 Learning Objectives
1. Explain the notions of „overhead costs‟, direct cost,
indirect, traceable cost and allocation base
2. Describe the difference between Support departments
and Producing departments.
3. Calculate charging rates, and distinguish between Single
and dual charging rates.
4. Allocate support center costs to producing departments using
the direct method, the sequential method, and the
reciprocal method.
5. Calculate departmental overhead rates.

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 Introduction
• When costs are allocated in the right way, the
business is able to trace the specific cost
objects that are making profits or losses for the
company.
• If costs are allocated to the wrong cost objects,
the company may be assigning resources to
cost objects that do not yield as much profits
as expected.

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 Overhead costs
• Overhead costs are indirect costs that are not
part of manufacturing costs.
• Overhead costs are not related to the labor or
material costs that are incurred in the
production of goods or services.
• Overhead costs support the production or
selling processes of the goods or services.
• Overhead costs are charged to the expense
account, and they must be continually paid
regardless of whether the company is selling
goods or not 4
examples
Some common of overhead costs are
rental expenses
utilities, insurance
postage
printing
administrative and legal expenses
research and development costs.

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Direct costs
Direct costs are costs that can be attributed to a
specific product or service.
Direct cost do not need to be allocated to the
specific cost object. because the organization
knows what expenses go to the specific
departments that generate profits and the costs
incurred in producing specific product or
service
Example direct material cost and direct labor
cost
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 Indirect costs
Indirect costs are costs that are not directly
related to a specific cost object like a function,
product, or department.
They are costs that are needed for the sake of
the company’s operations and health. Some
common examples of indirect costs include
security costs, administration costs, etc.

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 Supporting and Producing
Departments
• Supporting (Service) Department
– Are units within an organization that provide
essential support & services for producing
departments.
– Provides the services that assist other internal
departments in the company.
– Example - information systems, plant maintenance,
accounting, HR, maintenance, stores, etc.

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 Supporting and Producing
Departments
• Operating (Production) Department
– Are units within an organization that are directly
responsible for creating the products or services
sold to customers.
– Directly adds value to a product or service.
– Example –
• Manufacturing: machining, assembly, finishing, etc.
• Services: auditing, tax, management advisory, etc.

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Support Departments and
Producing Departments
Support departments provide
support for production departments

Producing departments are

responsible for the creation of
goods or services

Goods and Services

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Steps in Allocating Support Department
Costs to Producing Departments

1. Departmentalize the company.

2. Classify each department as a
support or producing
department.
3. Trace all overhead costs in the
company to a support or
producing department.

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Steps in Allocating Support Department Costs to
Producing Departments

4. Allocate support-department costs to the

producing departments.
5. Calculate predetermined overhead rates for
producing departments.
6. Allocate overhead costs to the units of
individual products through the
predetermined overhead rates.

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 General Purpose of Cost Allocation

Purposes

 To obtain a mutually agreeable price.

 To compute product-line profitability.
 To predict the economic effects of planning and control.
 To value inventory.
 To motivate managers and employees.

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 Examples of Cost Drivers for
Support Departments

Support Department Possible Driver

Accounting Number of transactions

Cafeteria Number of employees

Engineering Number of change orders

Number of hours
Maintenance Machine hours
Personnel Number of new hires
Direct labor cost
Purchasing Number of orders
Costs of orders

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 Examples of Cost Drivers for
Support Departments …

Support Department Possible Driver

Power Kilowatt-hour
Machine hours

Shipping Number of orders

Data processing Number of line entered

Number of hours of service
Maintenance Machine hours
Maintenance hours

Materials Storerooms Number of materials moves

Units of materials moved
Number of different parts
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 Methods to Allocate
Support Department Costs
• Single-Rate method – allocates costs in each
cost pool (service department) to cost objects
(production departments) using the same rate
per unit of a single allocation base
– No distinction is made between fixed and variable
costs in this method.
• Dual-Rate method – segregates costs within
each cost pool into two segments: a variable-
cost pool and a fixed-cost pool.
• Each pool uses a different cost-allocation base
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Allocation Method Tradeoffs
• Single-Rate method is simple to implement,
but treats fixed costs in a manner similar to
variable costs.

• Dual-Rate method treats fixed and variable

costs more realistically, but is more complex
to implement.

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 Allocation Bases
• Under either method, allocation of support
costs can be based on one of the three
following scenarios:
1. Budgeted overhead rate and budgeted allocation base
2. Budgeted overhead rate and actual allocation base
3. Actual overhead rate and actual allocation base

• Choosing between actual and budgeted rates:

budgeted is known at the beginning of the
period, while actual will not be known with
certainty until the end of the period.

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 Allocating One Department’s
Costs to Another Department
Single = Fixed costs + estimated variable costs
rate estimated usage
Dual rate: Fixed rate and a variable rate
• Developing a fixed rate
– Determine budgeted fixed costs
– Compute allocation ratio
– Allocate
• Developing the variable rate
– Depends on the costs that change as the activity driver
changes
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 A Single Charging Rate Example
 A firm developed an in-house photocopying department to
serve its three producing departments (audit, tax, and
management advisory systems or MAS).
 The costs of the photocopying department include fixed costs
of $26,190 per year and variable costs of $0.023 per page
copied.
 Estimated usage in pages by the three producing departments
is as follows:
Audit department 94,500
Tax department 67,500
MAS department 108,000
Total 270,000
======

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A Single Charging Rate Example…
o Total costs = $26,190 + (270,000 x $0.023) = $32,400
o Overhead rate = $32,400  270,000 = $0.12 per page

o Suppose the actual usage per department is:

Audit department 92,000
Tax department 65,000
MAS department 115,000
Total 272,000
======

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A Single Charging Rate Example…
• The total photocopying department charges would
be as shown:

# of OH Total
Pages rate Charges
Audit 92,000 $0.12 $11,040
Tax 65,000 $0.12 $7,800
MAS 115,000 $0.12 $13,800
Total $32,640
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 Dual (Multiple) Charging Rates

Peak Share FC
Pages (%) Total FC Allocated

Audit 7,875 20% $26,190 $ 5,238

Tax 23,625 60% $26,190 15,714

MAS 7,875 20% $26,190 5,238

Total 39,375 100% $26,190

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 Dual (Multiple) Charging Rates …

• The total photocopying department VC charges would be as shown:

# of VC
Pages rate VC
Audit 92,000 $0.023 $2,116

Tax 65,000 $0.023 $1,495

MAS 115,000 $0.023 $2,645

Total 272,000 $6,256

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 Dual (Multiple) Charging Rates …

• The total photocopying department charges would be as shown:

FC OH
VC Allocated Allocated

Audit $2,116 $ 5,238 $ 7,354

Tax 1,495 15,714 17,209

MAS 2,645 5,238 7,883

Total $6,256 $26,190 $32,446

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 Methods of Allocating Support
Costs to Production Departments

1. Direct Method
2. Sequential (Step-Down) Method
3. Reciprocal Method

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 Direct Method
• Allocates support costs only to Operating
(producing) Departments
• No Interaction between Support
Departments prior to allocation.

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 Direct Method
Support Departments Production Departments

Information Systems

Manufacturing

Packaging

Accounting 28
 Illustration:
Data Used in Cost Allocation

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 Illustration:
Data Used in Cost Allocation …
• Allocation bases:
• Cost of Plant Maintenance is allocated
based on Budgeted labor hours.

• Cost of Information System is allocated

based on Budgeted computer hours.

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Direct Allocation Method
Illustrated

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Direct Allocation Method Illustrated…

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 Step-Down Method
• Allocates support costs to other support
departments and to operating departments that
partially recognizes the mutual services provided
among all support departments.
• One-Way Interaction between Support
Departments prior to allocation.
• i.e., Costs allocations are performed in a step-down
fashion, using predetermined ranking procedures (e.g.,
degree of support, direct cost, etc).
• Once a support department’s costs are allocated it
never receives a subsequent allocation
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 Step-Down Method
Support Departments Production Departments

Information Systems

Manufacturing

Packaging

Accounting 34
Step-Down Allocation
Method Illustrated

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Step-Down Allocation
Method Illustrated ...

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 Reciprocal Method
• Allocates support department costs to
operating departments by fully recognizing
the mutual services provided among all
support departments.
• Full Two-Way Interaction between Support
Departments prior to allocation.
• Recognizes interactions of support departments
prior to allocation to producing departments.

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 Reciprocal Method
Support Departments Production Departments

Information Systems

Manufacturing

Packaging

Accounting 38
 Reciprocal Allocation Method Illustrated

Steps
• Step1: Express service department costs and service department
reciprocal relationships in the form of linear equation.

• Step 2: Solve the set of linear equations to obtain the

complete reciprocated costs of each service departments.

• Step 3: Allocate the complete reciprocated costs of each

service department to all other departments (both service
departments and operating departments) on the basis of cost
driver used.

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Step 1: Express in the form of Linear Equation

• Let PM be the reciprocated cost of Plant Maintenance.

• Let IS be the reciprocated cost of Information System.

• Then,
• PM = $6,300,000 + 0.1IS …………….. (1)
• IS = $1,452,150 + 0.2PM …………….. (2)

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Step 2: Solve the set of Linear Equations
• PM = $6,300,000 + 0.1($1,452,150 + 0.2PM )
• PM = $6,300,000 + $145,215 + 0.02PM
• PM = $6,445,215 + 0.02PM
• (1-0.02)PM = $6,445,215
• 0.98PM = $6,445,215
• PM = $6,445,215  0.98
• PM= $6,576,750
• IS = $1,452,150 + 0.2 ($6,576,750)
• IS = $1,452,150 + $1,315,350
• IS = $ 2,767,500
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Step 3: Allocate the complete reciprocated
costs all departments
• PM reciprocated cost allocation to:
• Info. System = 0.2 * $6,576,750 = $1,315,350
• Machining = 0.3 * $6,576,750 = $1,973,025
• Assembly = 0.5 * $6,576,750 = $3,288,375

• IS reciprocated cost allocation to:

• PM = 0.1 * $2,767,500 = $276,750
• Machining = 0.8 * $2,767,500 = $2,214,000
• Assembly = 0.1 * $2,767,500 = $276,750
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Reciprocal Allocation Method
(Linear Equations) Illustrated

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 Reciprocal Allocation
Method Illustrated ...
Support Operating
Departments Departments
Plant Information
Machining Assembly
Maintenance System

Budgeted OH Costs $6,300,000 $1,452,150 $4,000,000 $2,000,000

Allocation of PM (6,576,750) 1,315,350 1,973,025 3,288,375

Allocation of IS 276,750 (2,767,500) 2,214,000 276,750

Total OH $ 0 $ 0 $8,187,025 $5,565,125

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Chapter 5

The End

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