Cost Allocation
Chapter 6
© 2012 McGraw-Hill Education (Asia)
Cost Allocation and Charges for Services
Rendered

Intracompany – inside the same entity
This chapter will cover
reasons for establishment of an internal service
charging system or to have an cost allocation system

techniques
and principles of allocation to be used
allocation
of service department costs to operating
departments using the direct and step-down methods
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Slide 2
Cost Allocation and Charges for Services
Rendered

Intercompany – different entities within the same
group

Transfer pricing
may help group’s tax planning
may be monitored and scrutinized by tax authorities
and other interested regulating bodies/agents.
needs to be seen as an “arm’s length transaction”

Will be covered in Chapter 13 Appendix A



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Slide 3
Learning Objective 1
Explain the major reasons for
the need for allocating
nonmanufacturing costs.
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Slide 4
Service Department Charges
Operating
Departments
Service
Departments
Carry out central
purposes of
organization.
Do not directly
engage in
operating
activities.
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Slide 5
Reasons for Charging Service Department
Costs
Service department costs are charged to operating
departments for a variety of reasons including:
To encourage
operating departments
to wisely use service
department resources.
To provide operating
departments with
more complete cost
data for making
decisions.
To help measure the
profitability of
operating
departments.
To create an incentive
for service
departments to
operate efficiently.
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Slide 6
Management Needs

Need to understand the full cost of providing a product or
service (including supporting costs) to make better decision.
•
Ensuring competitive costing and pricing
•
Assessment of risk and potential success of the
product/service
•
Financial and operational forecasts and planning
•
Motivating performance evaluation and reward system
•
Communicating to employees about the importance of
recovering all indirect costs
•
Encouraging efficient and effective use of resources
•
Ensuring long-term sustainability and competitiveness
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Slide 7
Transfer Prices
The service department charges
considered can be viewed as a transfer
price that is charged for services
provided by service departments to
operating departments/companies
within the group.
Service
Departments
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$
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Operating
Departments
Slide 8
Factors To Be Considered For The Cost Allocation
Approach and Intercompany/Interdepartmental charges

Cost-benefit Evaluation
•

Cause and effect
•

Absorption of cost based on the ultimate benefactor
Ability to Bear
•

Absorption of cost based on who causes it
Benefit Received
•

Including tangible and intangible costs and benefits
Absorption of cost based on who/which product has the ability
and profit margin to bear the cost
Fairness or Equity
•
Ensuring fair game and decent profit to motive service provider,
for example, use of a cost-plus performance based award fee
approach, to ensure quality delivery of service/product
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Slide 9
Service Department Charges
© 2012 McGraw-Hill Education (Asia)
Learning Objective 2
Allocate costs of service
departments to other operating
departments/units using the cost
behavior concept.
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Slide 11
Charging Costs by Behavior
Whenever possible,
variable and fixed
service department costs
should be charged
separately.
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Slide 12
Charging Costs by Behavior
Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.
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Slide 13
Charging Costs by Behavior
Charge fixed service department costs to
consuming departments in predetermined
lump-sum amounts that are based on the
consuming department’s peak-period or longrun average servicing needs.
Are based on amounts of
capacity each consuming
department requires.
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Should not vary from
period to period.
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Slide 14
Should Actual or Budgeted Costs Be
Charged?
Budgeted variable
and fixed service department
costs should be charged to
operating departments.
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Slide 15
Sipco: An Example
Sipco has a maintenance department and two operating
departments: Cutting and Assembly. Variable maintenance
costs are budgeted at $0.60 per machine hour. Fixed
maintenance costs are budgeted at $200,000 per year.
Data relating to the current year are:
Allocate maintenance costs to the two operating departments.
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Slide 16
Sipco: End of the Year
Actual hours
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Slide 17
Sipco: End of the Year
Actual hours
Percent of peak-period capacity.
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Slide 18
Quick Check 
Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable
ambulance costs are budgeted at $4.20 per mile.
Fixed ambulance costs are budgeted at $120,000
per year. Data relating to the current year are:
Hospitals
Mercy
Northside
Total
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Percent of
Peak-Period
Capacity
Required
45%
55%
100%
Miles
Planned
15,000
17,000
32,000
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Miles
Used
16,000
17,500
33,500
Slide 19
Quick Check 
How much ambulance service cost will be
allocated to Mercy Hospital at the end of the
year?
a. $121,200
b. $254,400
c. $139,500
d. $117,000
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Slide 20
Quick Check 
How much ambulance service cost will be
allocated to Mercy Hospital at the end of the
year?
a. $121,200
b. $254,400
c. $139,500
d. $117,000
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Slide 21
Pitfalls in Allocating Fixed Costs
Allocating fixed
costs using a variable
allocation base.
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Result
Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.
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Slide 22
Pitfalls in Allocating Fixed Costs
Using sales
dollars as an
allocation base.
Result
Sales of one department
influence the service
department costs
allocated to other
departments.
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Slide 23
Autos R Us – An Example
Autos R Us has one service department and three
sales departments, New Cars, Used Cars, and Car
Parts. The service department costs total $80,000
for both years in the example.
Contrary to good practice, Autos R Us allocates the
service department costs based on sales.
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Slide 24
Autos R Us – First-year Allocation
Sales by department
$
Percentage of total sales
Allocation of service
department costs
$
New
1,500,000
50%
40,000
$1,500,000 ÷ $3,000,000
Departments
Used
$ 900,000
30%
$
24,000
Parts
$ 600,000
20%
$
$
$
16,000
Total
3,000,000
100%
80,000
50% of $80,000
In the next year, the manager of the New Cars department
increases sales by $500,000. Sales in the other departments
are unchanged. Let’s allocate the $80,000 service department
cost for the second year given the sales increase.
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Slide 25
Autos R Us – Second-year Allocation
Sales by department
$
Percentage of total sales
Allocation of service
department costs
$
Departments
New
Used
2,000,000
$ 900,000
57%
26%
45,714
$2,000,000 ÷ $3,500,000
$
20,571
Parts
$ 600,000
17%
$
$
$
13,714
Total
3,500,000
100%
80,000
57% of $80,000
If you were the manager of the New Cars department, would
you be happy with the increased service department
costs allocated to your department?
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Slide 26
Service Department Allocations
© 2012 McGraw-Hill Education (Asia)
Operating Departments
An operating department carries out
the central purpose of the organization
The Surgery
Department
at Mount
Sinai
Hospital.
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The
Geography
Department
at the
University of
Washington.
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A
Production
Department
at
Mitsubishi.
Slide 28
Service Departments
Service departments do not directly
engage in operating activities.
The
Accounting
Department
at Macy’s.
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The Human
Resources
Department
at Walgreens.
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Slide 29
Interdepartmental Services
Service
Department
Operating
Department
Costs of the service
department become
overhead costs to
the operating
department
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Slide 30
Allocation Approaches
Direct
Method

Step-Down
Method

Reciprocal
Method
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
Slide 31
Reciprocal Services
Service
Department 1
Service
Department 2
When service
departments provide
services to each
other we call them
reciprocal services.
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Slide 32
Learning Objective 3
Allocate service
department costs to
operating departments
using the direct method.
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Slide 33
Direct Method
Interactions
between service
departments are
ignored and all
costs are
allocated directly
to operating
departments.
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Service
Department
(Cafeteria)
Operating
Department
(Machining)
Service
Department
(Custodial)
Operating
Department
(Assembly)
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Slide 34
Direct Method – An Example
Service Department
Allocation Base
Cafeteria
Custodial
Number of employees
Square feet occupied
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Slide 35
Direct Method – An Example
How much of the Cafeteria and Custodial costs
should be allocated to each operating department
using the direct method of cost allocation?
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Slide 36
Direct Method – An Example
20
$360,000 ×
= $144,000
20 + 30
Allocation base: Number of employees
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Slide 37
Direct Method – An Example
$360,000 ×
30
= $216,000
20 + 30
Allocation base: Number of employees
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Slide 38
Direct Method – An Example
25,000
$90,000 ×
25,000 + 50,000
= $30,000
Allocation base: Square feet occupied
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Slide 39
Direct Method – An Example
50,000
$90,000 ×
25,000 + 50,000
= $60,000
Allocation base: Square feet occupied
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Slide 40
Learning Objective 4
To allocate service
department costs to
operating departments
using the step-down
method.
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Slide 41
Step-Down Method
Once a service
department’s costs
are allocated,
other service
department costs
are not allocated
back to it.
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Service
Department
(Cafeteria)
Operating
Department
(Machining)
Service
Department
(Custodial)
Operating
Department
(Assembly)
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Slide 42
Step-Down Method
There are three key points to understand regarding
the step-down method:
 In both the direct and step-down methods, any
amount of the allocation base attributable to the
service department whose cost is being allocated is
always ignored.
 Any amount of the allocation base that is
attributable to a service department whose cost has
already been allocated is ignored.
 Each service department assigns its own costs to
operating departments plus the costs that have
been allocated to it from other service departments.
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Slide 43
Step-Down Method – An Example
We will use the same data used
in the direct method example.
Service Department
Allocation Base
Cafeteria
Custodial
Number of employees
Square feet occupied
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Slide 44
Step-Down Method – An Example
Allocate Cafeteria costs first since
it provides more service than Custodial.
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Slide 45
Step-Down Method – An Example
10
$360,000 ×
10 + 20 + 30
= $60,000
Allocation base: Number of employees
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Slide 46
Step-Down Method – An Example
20
$360,000 ×
10 + 20 + 30
= $120,000
Allocation base: Number of employees
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Slide 47
Step-Down Method – An Example
30
$360,000 ×
10 + 20 + 30
= $180,000
Allocation base: Number of employees
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Slide 48
Step-Down Method – An Example
New total = $90,000 original Custodial cost
plus $60,000 allocated from the Cafeteria.
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Slide 49
Step-Down Method – An Example
25,000
$150,000 ×
25,000 + 50,000
= $50,000
Allocation base: Square feet occupied
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Slide 50
Step-Down Method – An Example
50,000
$150,000 ×
25,000 + 50,000
= $100,000
Allocation base: Square feet occupied
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Slide 51
Reciprocal Method
Interdepartmental
services are given
full recognition
rather than partial
recognition as with
the step method.
Service
Department
(Cafeteria)
Operating
Department
(Machining)
Service
Department
(Custodial)
Operating
Department
(Assembly)
Because of its mathematical complexity,
the reciprocal method is rarely used.
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Slide 52
Quick Check Data
for Direct and Step-Down Methods
The direct method of allocation is used.
Allocation bases:
Business school administration costs (ADMIN):
Number of employees
Business
Administration computer services (BACS):
Number of personal computers
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Slide 53
Quick Check 
How much cost will be allocated from
Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
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Slide 54
Quick Check 
How much cost will be allocated from
Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
20
$180,000 ×
= $36,000
20 + 80
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Slide 55
Quick Check 
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
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Slide 56
Quick Check 
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
$90,000 ×
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18
= $13,500
18 + 102
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Slide 57
Quick Check Data
The step method of allocation is used.
Allocation bases:
Business school administration costs (ADMIN):
Number of employees
Business
administration computer services (BACS):
Number of personal computers
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Slide 58
Quick Check 
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
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Slide 59
Quick Check 
How much total cost will be allocated from
ADMIN and BACS combined to the Accounting
Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
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Slide 60
End of Chapter 6
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