part a cost allocation

7/28/2019 Part a Cost Allocation

1/45

Cost Allocation

Unit 4


2/45

Learning Objective 1

Allocation of Service

Department Cost


3/45

Department Cost

Producing Departments which include theproduction lines, are the cost accumulation centers inwhich work is performed directly on the goods beingproduced.

Service Departments which include such activitiesas maintenance, personnel, employee services, andthe provision of heat, power and light are necessary for

the entire factory including the producing departmentsto remain in operation.


4/45

Operating Departments

Anoperating department carries outthe central purpose of the organization

The SurgeryDepartment

at Mount

SinaiHospital.

AProductionDepartment

atMitsubishi.

TheGeographyDepartment

at the

University ofWashington.


5/45

Service Departments

Service departments do not directlyengage in operating activities.

TheAccountingDepartment

at Macys.

The HumanResourcesDepartment

at Walgreens.


6/45

Methods to Allocate

Support Department Costs

Single-rate methodallocates costs in each cost pool

(service department) to cost objects (productiondepartments) using the same rate per unit of a singleallocation base

No distinction is made between fixed and variable costs

in this method.


7/45

Methods to Allocate

Support Department Costs

Dual-rate methodsegregates costs within each cost

pool into two segments: a variable-cost pool and afixed-cost pool.

Each pool uses a different cost-allocation base.


8/45

Allocation Method Trade-Offs

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.


9/45

Allocation Bases Under either method, allocation of support costs

can be based on one of the three followingscenarios:

1. Budgeted overhead rate and budgeted hours2. Budgeted overhead rate and actual hours3. Actual overhead rate and actual hours

Choosing between actual and budgeted rates:

budgeted is known at the beginning of the period,whereas actual will not be known with certaintyuntil the end of the period


10/45

Level to use

Activity Level to Use


11/45

Factors to be considered in the computation of

Overhead Rate

ACTIVITY LEVEL TO USE

In the estimation of manufacturing overhead, as well as theestimation of the base to be used for allocation, it is important todetermine what capacity of production should be adopted.

a. Ideal capacity

b. Practical capacity

c. Master-budget capacity

d. Normal capacity


12/45


a. Ideal or Theoretical is the level of capacity based onproducing at full efficiency.

b. Practical capacity is the level of capacity that reducestheoretical capacity by considering unavoidable operatinginterruptions, such as scheduled maintenance time, shut-downs for holidays and so on.

Note:

Both theoretical and practical capacity measures capacity interms of WHAT A PLANT CAN SUPPLY - availablecapacity. With difficulty, practical capacity is attainable.


13/45


c. Master-budget capacityis the level of capacity utilization

that managers expect for the current budget period, which istypically one year.

d. Normal capacity is the level of capacity utilization thatsatisfies average customer demand over a period (say two

or three years) that includes seasonal, cyclical and trendfactors. This capac i ty is commonly used in thecom putat ions o f overhead rates.

Note:

In contrast, normal and master budget capacity utilizationmeasures capacity level in terms ofDEMAND for the output of theplant, that is the amount of available capacity the plant expects touse based on the demand for its products.


14/45

Predetermined Overhead Rate and Capacity

Calculating predetermined overhead rates using anestimated, or budgeted amount of the allocation basehas been criticized because:

1.Basing the predetermined overhead rate uponbudgeted activity results in product costs that fluctuatedepending upon the activity level.

2.Calculating predetermined rates based upon

budgeted activity charges products for costs that theydo not use.


15/45

Capacity-Based Overhead Rates

Criticisms can be overcome by usingestimated total units in the allocation base

at capacity in the denominator of the

predetermined overhead rate calculation.

Lets look at the difference!


16/45

An Example

Equipment is leased for $100,000 peryear. Running at full capacity, 50,000units may be produced. The company

estimates that 40,000 units will beproduced and sold next year. What is

the predetermined overhead rate?


17/45

An Example

Equipment is leased for $100,000 per year.Running at full capacity, 50,000 units may be

produced. The company estimates that 40,000 unitswill be produced and sold next year.

TraditionalMethod

= $2.50 per unit$100,000

40,000=

CapacityMethod

= $2.00 per unit$100,00050,000

=


18/45

Income Statement Preparation Capacity

Actual volume 40,000 casesSelling price $40.00 per case

Variable production cost $24.00 per case

Fixed manufacturing overhead $100,000 per year

Capacity 50,000 cases

Predetermined overhead rate $2.00 per caseFixed selling and admin. expense $500,000 per year

Revenue 1,600,000$

Cost of goods sold 1,040,000

Gross margin 560,000Cost of idle capacity 20,000

Selling and admin. expense 500,000

Net operating income 40,000$


19/45

Allocation Costs of Multiple Support Departments

DirectMethod

Step-DownMethod

ReciprocalMethod


20/45

Direct Method

ServiceDepartment(Cafeteria)

Service

Department(Custodial)

OperatingDepartment(Machining)

Operating

Department(Assembly)

Interactionsbetween servicedepartments areignored and all

costs areallocated directly

to operating

departments.


21/45

Direct Method An Example

Service Department Allocation Base

Cafeteria Number of employees

Custodial Square feet occupied


22/45


How much of the Cafeteria and Custodial costsshould be allocated to each operating department

using the direct method of cost allocation?


23/45


Allocation base: Number of employees

$360,000 2020 + 30

= $144,000


24/45



$360,000 3020 + 30

= $216,000


25/45


Allocation base: Square feet occupied

$90,000 25,00025,000 + 50,000

= $30,000


26/45



50,00025,000 + 50,000

$90,000 = $60,000


27/45


Operating

Department(Assembly)

Step-Down Method

Once a servicedepartments costs

are allocated,other service

department costsare not allocated

back to it.


Service

Department(Custodial)


28/45

Step-Down Method

Also called the sequential allocation method

Allocates support-department costs to other supportdepartments and to operating departments in a

sequential manner Partially recognizes the mutual services provided

among all support departments


29/45




We will use the same data usedin the direct method example.

Step-Down Method An Example


30/45

Allocate Cafeteria costs first sinceit provides more service than Custodial.



31/45

$360,000 1010 + 20 + 30

= $60,000




32/45

$360,000 2010 + 20 + 30

= $120,000




33/45

$360,000 3010 + 20 + 30

= $180,000




34/45

New total = $90,000 original Custodial costplus $60,000 allocated from the Cafeteria.



35/45

$150,000 25,00025,000 + 50,000

= $50,000




36/45


37/45

Reciprocal or Algebraic Method

Interdepartmentalservices are given

full recognition

rather than partialrecognition as withthe step method.


ServiceDepartment

(Custodial)


OperatingDepartment

(Assembly)


38/45

This process requires three steps:

1. Express support department costs and reciprocal relationships inthe form of Linear Equations.

2. Solve the set of Linear Equations to obtain the completereciprocated costs of each support department.

3. Allocate the complete reciprocated costs of each supportdepartment to all other departments (both support and operatingdepartments)


39/45




We will use the same data usedin the direct method example.

Reciprocal Method An Example


40/45

Cafeteria = $360,000 + .0625 (Custodial)Custodial = $90,000 + .1667 (Cafeteria)

Cafeteria = $360,000 + .0625 ($90,000 +.1667 Cafeteria)= $360,000 + $5,625 + .0104 Cafeteria

= $365,625 / .9896= $369,467

Custodial = $90,000 +.1667 ($369,467)= $90,000 + $61,590= $151,590

Cafeteria Custodial

Machining 33.33% 31.25%

Assembly 50% 62.5%

Cafeteria - 6.25%

Custodial 16.67% -

Reciprocal Method An Example


41/45

Machining Assembly Cafeteria Custodial

Budgeted FO $400,000 $700,000 $ 360,000 $ 90,000

Allocated FO

Cafeteria $123,143 $184,734 ($369,467) $ 61,590

Custodial $ 47,373 $ 94,743 $ 9,474 ($151,590)

Total FO $570,516 $979,477 -7 -

Reciprocal Method An ExampleCafeteria Custodial

Machining 33.33% 31.25%

Assembly 50% 62.5%

Cafeteria - 6.25%

Custodial 16.67% -


42/45

Data Used in Cost Allocation

Illustrations


43/45

Reciprocal Allocation Method (Repeated

Iterations) Illustrated


44/45

Choosing Between Methods

Reciprocal is the most precise.

Direct and step-down are simple to compute andunderstand.

Direct method is widely used.


45/45

End of Unit 4

part a cost allocation

Documents