14-34 (40 min.) Allocation of corporate costs to divisions.
1.
The purposes for allocating central corporate costs to each division include the following (students
may pick and discuss any two):
a.
To provide information for economic decisions. Allocations can signal to division managers
that decisions to expand (contract) activities will likely require increases (decreases) in corporate
costs that should be considered in the initial decision about expansion (contraction). When top
management is allocating resources to divisions, analysis of relative division profitability should
consider differential use of corporate services by divisions. Some allocation schemes can
encourage the use of central services that would otherwise be underutilized. A common rationale
related to this purpose is “to remind profit center managers that central corporate costs exist and
that division earnings must be adequate to cover some share of those costs.”
b.
Motivation. Allocations create incentives for division managers to control costs; for example,
by reducing the number of employees at a division, a manager will save direct labor costs as well
as central personnel and payroll costs allocated on the basis of number of employees. Allocation
also creates incentives for division managers to monitor the effectiveness and efficiency with
which central corporate costs are spent.
c.
Cost justification or reimbursement. Some lines of business of Richfield Oil may be regulated
with cost data used in determining “fair prices”; allocations of central corporate costs will result
in higher prices being set by a regulator.
d.
Income measurement for external parties. Richfield Oil may include allocations of central
corporate costs in its external line-of-business reporting.
2.
Revenues
Percentage of revenues
$8,000; $16,000; $4,800; $3,200 
$32,000
(Dollar amounts in millions)
Revenues
Operating costs
Operating income
Corp. costs allocated on revenues
(% of revs  $3,228)
Division operating income
3.
Oil & Gas
Upstream
$8,000
Oil & Gas Chemical
Downstream Products
$16,000
$4,800
25%
Oil & Gas
Upstream
$8,000
3,000
5,000
50%
15%
Oil & Gas Chemical
Downstream Products
$16,000
$4,800
15,000
3,800
1,000
1,000
807
$4,193
$
1,614
(614)
484
$ 516
Copper
Mining
$3,200
10%
Total
$32,000
100%
Copper
Mining
$3,200
3,500
(300)
Total
$32,000
25,300
6,700
323
$ (623)
3,228
$ 3,472
First, calculate the share of each allocation base for each of the four corporate cost pools:
Identifiable assets
(1) Percentage of total identifiable assets
$14,000; $6,000; $3,000; $2,000  $25,000
Oil & Gas
Upstream
$14,000
56%
Division revenues
(2) Percentage of total division revenues
$8,000; $16,000; $4,800; $3,200  $32,000
$8,000
Positive operating income
(3) Percentage of total positive operating income
$5,000; $1,000; $1,000; 0  $7,000
$5,000
Number of employees
(4) Percentage of total employees
9,000; 12,000; 6,000; 3,000  30,000
Oil & Gas
Downstream
$6,000
24%
$16,000
25%
50%
$1,000
71.43%
9,000
14.29%
12,000
30%
40%
Chemical
Products
$3,000
12%
$4,800
15%
$1,000
14.29%
6,000
20%
Copper
Mining
$2,000
8%
$3,200
10%
NONE
0%
3,000
10%
Total
$25,000
100%
$32,000
100%
$7,000
100%
30,000
100%
Using these allocation percentages and the allocation bases suggested by Rhodes, we can allocate the $3,228 M of corporate costs as
shown below. Note that the costs in Cost Pool 2 total $800 M ($150 + $110 + $200 + $140 + $200).
(Dollar amounts in millions)
Revenues
Operating Costs
Operating Income
Cost Pool 1 Allocation ((1)  $2,000)
Cost Pool 2 Allocation ((2)  $800)
Cost Pool 3 Allocation ((3)  $203)
Cost Pool 4 Allocation ((4)  $225)
Division Income
Oil & Gas
Upstream
$8,000.00
3,000.00
5,000.00
1,120.00
200.00
145.00
67.50
$3,467.50
Oil & Gas
Downstream
$16,000.00
15,000.00
1,000.00
480.00
400.00
29.00
90.
00
$
1.00
Chemical
Products
$4,800.00
3,800.00
1,000.00
240.00
120.00
29.00
Copper
Mining
$3,200.00
3,500.00
(300.00)
160.00
80.00
0.00
Total
$32,000
25,300
6,700
2,000
800
203
45.00
$ 566.00
22.50
$ (562.50)
225
$ 3,472
4.
The table below compares the reported income of each division under the original revenue-based
allocation scheme and the new four-pool-based allocation scheme. Oil & Gas Upstream seems 17% less
profitable than before ($3,467.5  $4,193 = 83%) and may resist the new allocation, but each of the other
divisions seem more profitable (or less loss-making) than before, and they will probably welcome it. In this
setting, corporate costs are relatively large [about 13% ($3,228 ÷ $25,300) of total operating costs], and
division incomes are sensitive to the corporate cost allocation method.
(Dollar amounts in millions)
Operating Income
(before corp. cost allocation)
Division income under revenue-based
allocation of corporate costs
Division income under four-cost-pool
allocation of corporate costs
Oil & Gas
Upstream
Oil & Gas
Downstream
Chemical
Products
Copper
Mining
Total
$5,000.00
$1,000.00
$1,000.00
$(300.00)
$6,700
$4,193.00
$ (614.00)
$ 516.00
$(623.00)
$3,472
$3,467.50
$
$ 566.00
$(562.50)
$3,472
1.00
Strengths of Rhodes’ proposal relative to existing single-cost pool method:
a.
b.
Better able to capture cause-and-effect relationships. Interest on debt is more likely caused by the
financing of assets than by revenues. Personnel and payroll costs are more likely caused by the number
of employees than by revenues.
Relatively simple. No extra information need be collected beyond what is already available. (Some
students will list the extra costs of Rhodes’ proposal as a weakness. However, for a company with $32
billion in revenues, those extra costs are minimal.)
Weaknesses of Rhodes’ proposal relative to existing single-cost pool method:
a.
May promote dysfunctional decision making. May encourage division managers to lease or rent assets
rather than to purchase assets, even where it is economical for Richfield Oil to purchase them. This
off-balance sheet financing will reduce the “identifiable assets” of the division and thus will reduce
the interest on debt costs allocated to the division. (Richfield Oil could counteract this problem by
incorporating leased and rented assets in the “identifiable assets” base.)
Note: Some students criticized Rhodes’ proposal despite agreeing that it is preferable to the existing singlecost-pool method. These criticisms include:
a.
b.
c.
d.
e.
The proposal does not adequately capture cause-and-effect relationships for the legal and research and
development cost pools. For these cost pools, specific identification of individual projects with an
individual division can better capture cause-and-effect relationships.
The proposal may give rise to disputes over the definition and valuation of “identifiable assets.”
The use of actual rather than budgeted amounts in the allocation bases creates interdependencies
between divisions. Moreover, use of actual amounts means that division managers do not know cost
allocation consequences of their decisions until the end of each reporting period.
A separate allocation of fixed and variable costs would result in more refined cost allocations.
It is questionable that 100% of central corporate costs should be allocated. Many students argue that
public affairs should not be allocated to any division, based on the notion that division managers may
not control many of the individual expenditures in this cost pool.
14-35 (30 min.) Cost allocation to divisions.
1.
Segment margin
Allocated headquarter costs
($5,100,000 ÷3)
Operating income
Bread
$6,400,000
Cake
$1,300,000
Doughnuts
$6,150,000
Total
$13,850,000
1,700,000
$4,700,000
1,700,000
$ (400,000)
1,700,000
$4,450,000
5,100,000
$ 8,750,000
2.
Segment margin
Allocated headquarter costs,
Human resources1
(50%; 12.5%; 37.5% ×
$1,900,000)
Accounting department2
(53.9%; 11.6%; 34.5% ×
$1,400,000)
Rent and depreciation3
(50%; 20%; 30% ×
$1,200,000)
1

Other   $600, 000 
3

Total
Operating income
Bread
$6,400,000
Cake
$1,300,000
Doughnuts
$6,150,000
Total
$13,850,000
950,000
237,500
712,500
1,900,000
754,600
162,400
483,000
1,400,000
600,000
240,000
360,000
1,200,000
200,000
200,000
200,000
600,000
2,504,600
$3,895,400
839,900
$ 460,100
1,755,500
$4,394,500
5,100,000
$ 8,750,000
1
Total number of employees= 400+100+ 300=800;
HR costs allocation %age: 400 ÷800 = 50%; 100 ÷800 = 12.5%; 300 ÷800 = 37.5%
2
Total revenues=$20,900,000 + $4,500,000 + $13,400,000 = $38,800,000;
Accounting costs allocation %age: $20,900,000 ÷ $38,800,000 = 53.9%; $4,500,000 ÷ $38,800,000 = 11.6%;
$13,400,000 ÷$38,800,000 = 34.5%
3
Total square feet of space = 10,000 + 4,000 + 6,000 = 20,000
Rent and depreciation costs allocation %age: 10,000 ÷20,000 = 50%; 4,000 ÷20,000 = 20%; 6,000 ÷20,000 = 30%
A cause-and-effect relationship may exist between Human Resources costs and the number of employees at
each division. Rent and depreciation costs may be related to square feet, except that very expensive
machines may require little square footage, which is inconsistent with this choice of allocation base. The
Accounting Department costs are probably related to the revenues earned by each division—higher revenues
mean more transactions and more accounting. Other overhead costs are allocated arbitrarily.
3.
The manager who suggested the new allocation bases probably works in the Cake Division. Under
the old scheme, the Cake Division shows an operating loss after allocating headquarter costs because it is
smaller, yet was charged an equal amount (a third) of headquarter costs. The new allocation scheme shows
an operating profit in the Cake Division, even after allocating headquarter costs. The ABC method is a
better way to allocate headquarter costs because it uses cost allocation bases that, by and large, represent
cause-and-effect relationships between various categories of headquarter costs and the demands that
different divisions place on these costs.
15-17 (20–25 min.) Single-rate method, budgeted versus actual costs and quantities.
1. a. Budgeted rate =
Budgeted indirect costs
= $115,000/50 trips = $2,300 per round-trip
Budgeted trips
Indirect costs allocated to Dark Choc. Division = $2,300 per round-trip  30 budgeted round trips
= $69,000
Indirect costs allocated to Milk Choc. Division = $2,300 per round-trip  20 budgeted round trips
$46,000
=
b. Budgeted rate = $2,300 per round-trip
Indirect costs allocated to Dark Choc. Division = $2,300 per round-trip  30 actual round trips
= $69,000
Indirect costs allocated to Milk Choc. Division = $2,300 per round-trip  15 actual round trips
= $34,500
c. Actual rate =
Actual indirect costs
= $96,750/ 45 trips = $2,150 per round-trip
Actual trips
Indirect costs allocated to Dark Choc. Division = $2,150 per round-trip  30 actual round trips
= $64,500
Indirect costs allocated to Milk Choc. Division = $2,150 per round-trip  15 actual round trips
= $32,250
2.
When budgeted rates/budgeted quantities are used, the Dark Chocolate and Milk Chocolate Divisions
know at the start of 2017 that they will be charged a total of $69,000 and $46,000, respectively, for
transportation. In effect, the fleet resource becomes a fixed cost for each division. Then, each may be
motivated to over-use the trucking fleet, knowing that their 2017 transportation costs will not change.
When budgeted rates/actual quantities are used, the Dark Chocolate and Milk Chocolate Divisions
know at the start of 2017 that they will be charged a rate of $2,300 per round trip, i.e., they know the price per
unit of this resource. This enables them to make operating decisions knowing the rate they will have to pay
for transportation. Each can still control its total transportation costs by minimizing the number of round trips
it uses. Assuming that the budgeted rate was based on honest estimates of their annual usage, this method will
also provide an estimate of the excess trucking capacity (the portion of fleet costs not charged to either
division). In contrast, when actual costs/actual quantities are used, the two divisions must wait until year-end
to know their transportation charges.
The use of actual costs/actual quantities makes the costs allocated to one division a function of the actual demand of other
users. In 2017, the actual usage was 45 trips, which is 5 trips below the 50 trips budgeted. The Dark Chocolate Division used all the
30 trips it had budgeted. The Milk Chocolate Division used only 15 of the 20 trips budgeted. When costs are allocated based on
actual costs and actual quantities, the same fixed costs are spread over fewer trips resulting in a higher rate than if the Milk Chocolate
Division had used its budgeted 20 trips. As a result, the Dark Chocolate Division bears a proportionately higher share of the fixed
costs.
Using actual costs/actual rates also means that any efficiencies or inefficiencies of the trucking fleet get passed along to
the user divisions. In general, this will have the effect of making the truck fleet less careful about its costs although, in 2017, it
appears to have managed its costs well, leading to a lower actual cost per roundtrip relative to the budgeted cost per round trip.
For the reasons stated previously, of the three single-rate methods suggested in this problem, the budgeted rate and actual
quantity may be the best one to use. (The management of Chocolat Inc. would have to ensure that the managers of the Dark Chocolate
and Milk Chocolate divisions do not systematically overestimate their budgeted use of the fleet division in an effort to drive down
the budgeted rate).
15-18
(20 min.)Dual-rate method, budgeted versus actual costs and quantities (continuation of 15-17).
1. Charges with dual rate method.
Variable indirect cost rate
=
$1,350 per trip
Fixed indirect cost rate
=
=
$47,500 budgeted costs/ 50 round trips budgeted
$950 per trip
Dark Chocolate Division
Variable indirect costs, $1,350 × 30
Fixed indirect costs, $950 × 30
Milk Chocolate Division
Variable indirect costs, $1,350 × 15
Fixed indirect costs, $950 × 20
$40,500
28,500
$69,000
$20,250
19,000
$39,250
2.
The dual rate changes how the fixed indirect cost component is treated. By using budgeted trips made,
the Dark Chocolate Division is unaffected by changes from its own budgeted usage or that of other divisions.
When budgeted rates and actual trips are used for allocation (see requirement 1.b. of problem 15-17), the Dark
Chocolate Division is assigned the same $28,500 for fixed costs as under the dual-rate method because it made
the same number of trips as budgeted. However, note that the Milk Chocolate Division is allocated $19,000
in fixed trucking costs under the dual-rate system, compared to $950  15 actual trips = $14,250 when actual
trips are used for allocation. As such, the Dark Chocolate Division is not made to appear disproportionately
more expensive than the Milk Chocolate Division simply because the latter did not make the number of trips
it budgeted at the start of the year.
15-19 (30 min.) Support department cost allocation; direct and step-down methods.
1.
AS
IS
GOVT
CORP
a. Direct method costs
$600,000 $2,400,000
Alloc. of AS costs
(40/75, 35/75)
(600,000)
$ 320,000
$ 280,000
Alloc. of IS costs
(30/90, 60/90)
(2,400,000)
800,000
1,600,000
$
0 $
0
$1,120,000
$1,880,000
b. Step-down (AS first) costs
$600,000 $2,400,000
Alloc. of AS costs
(0.25, 0.40, 0.35)
(600,000)
150,000
$ 240,000
$ 210,000
Alloc. of IS costs
(30/90, 60/90)
(2,550,000)
850,000
1,700,000
$
0 $
0
$1,090,000
$1,910,000
c.
Step-down (IS first) costs
Alloc. of IS costs
(0.10, 0.30, 0.60)
Alloc. of AS costs
(40/75, 35/75)
2.
Direct method
Step-down (AS first)
Step-down (IS first)
$600,000 $2,400,000
240,000 (2,400,000)
(840,000)
$
0 $
0
$ 720,000
$1,440,000
448,000
$1,168,000
392,000
$1,832,000
GOVT
$1,120,000
1,090,000
1,168,000
CORP
$1,880,000
1,910,000
1,832,000
The direct method ignores any services to other support departments. The step-down method partially
recognizes services to other support departments. The information systems support group (with total budget
of $2,400,000) provides 10% of its services to the AS group. The AS support group (with total budget of
$600,000) provides 25% of its services to the information systems support group. When the AS group is
allocated first, a total of $2,550,000 is then assigned out from the IS group. Given CORP’s disproportionate
(2:1) usage of the services of IS, this method then results in the highest overall allocation of costs to CORP.
By contrast, GOVT’s usage of the AS group exceeds that of CORP (by a ratio of 8:7), and so GOVT is
assigned relatively more in support costs when AS costs are assigned second, after they have already been
incremented by the AS share of IS costs as well.
3.
Three criteria that could determine the sequence in the step-down method are as follows:
a. Allocate support departments on a ranking of the percentage of their total services provided to
other support departments.
1. Administrative Services
25%
2. Information Systems
10%
b. Allocate support departments on a ranking of the total dollar amount in the support departments.
1. Information Systems
$2,400,000
2. Administrative Services $ 600,000
c. Allocate support departments on a ranking of the dollar amounts of service provided to other
support departments
1. Information Systems
(0.10  $2,400,000)
=
$240,000
2. Administrative Services
(0.25  $600,000)
=
$150,000
The approach in (a) above typically better approximates the theoretically preferred reciprocal method.
It results in a higher percentage of support-department costs provided to other support departments being
incorporated into the step-down process than does (b) or (c), above.