10
Managing and
Allocating SupportService Costs
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
10-2
The Service-Cost Challenge
The goal of an organization is to achieve the
objectives that prompted the creation of
the organization in the first place.
Nonprofit hospitals superior health care
(while covering their
costs of operation)
City governments essential services
to their citizens
(within budgetary
limits)
Commercial firms goods and services
(while earning a
competitive profit)
10-3
The Service-Cost Challenge
Achieving the goals of the organization requires
using scarce resources and making complex
trade-offs among competing uses.
Needed:
Reliable quantitative and
qualitative cost
management information
about relative costs and
benefits of alternatives.
10-4
Internal or Outsourced Support
Services?
Factors to be considered
Are service
providers reliable?
How do the
costs compare?
Is the function
strategic to us?
Who has the
more adequate
knowledge base?
10-5
Learning Objective 1
10-6
Managing Internal Support-Service
Costs
Cost allocation is the process of assigning
indirect costs to cost objects.
Indirect
costs
Indirect costs are
common costs
of shared facilities
or services.
Cost Allocation
Cost
Object
Cost objects can be:
•Departments benefiting
from services
•Time periods when
services were provided
10-7
Managing Internal Support-Service
Costs
Alternatives
Do not charge
internal customers
for support services
and recover the
costs from general
revenues.
Internal customers
may overuse a
free good.
Charge the cost of
support services to
using departments
and possibly recover
the costs from these
internal customers.
DISADVANTAGES
10-8
Managing Internal Support-Service
Costs
Alternatives
Charge the cost of
support services to
using departments
and possibly recover
the costs from these
internal customers.
Do not charge
internal customers
for support services
and recover the
costs from general
revenue.
Allocations are arbitrary
 Rates subject to dispute
 May discourage use

DISADVANTAGES
10-9
Managing Internal Support-Service
Costs
My performance looked
good until they
allocated those service
department costs, so
I’m not going to use
the service again.
But that would not be
beneficial to the company.
What if we charged a flat
annual fee for the service?
10-10
Managing Internal Support-Service
Costs
That sounds better.
If the fee is fixed,
the more I use the
service the lower my
average cost per
use will be.
Is that
really
what we
want?
10-11
Cost Allocation from Service
Departments to Internal Customers
How are service
department costs
charged to production
departments?
First, we identify the activities
that drive costs in each
service department.
This cost driver is called
the allocation base.
10-12
Cost Allocation from Service
Departments to Internal Customers
How are service
department costs
charged to production
departments?
Second, we measure the
consumption of the
allocation base in the
production departments.
10-13
Cost Allocation from Service
Departments to Internal Customers
How are service
department costs
charged to production
departments?
Third, we allocate the service
department cost based on
the relative amount of the
allocation base used in
each production department.
10-14
Cost Allocation from Service
Departments to Internal Customers
What happens to
service department
costs after they are
allocated to production
departments?
The production department might
reimburse the service department,
but most likely the allocated
service department costs
become a part of the
manufacturing overhead in
the production department.
10-15
Cost Allocation from Service
Departments to Internal Customers
I get it. They become
a part of the overhead
that is applied to
products with a
predetermined
overhead rate.
That’s right. Take a look at
this flow chart.
I think it will summarize
our discussion of the
allocation process.
10-16
Cost Allocation from Service
Departments to Internal Customers
Service
department
(cafeteria)
Service
department
(accounting)
Service
department
(personnel)
First Stage Allocations
Service department costs are
allocated to production departments.
Production
department
(machining)
Production
department
(assembly)
The
product
10-17
Cost Allocation from Service
Departments to Internal Customers
Service
Department
(Cafeteria)
Service
Department
(Accounting)
Service
Department
(Personnel)
Second Stage Allocations
Producing department overhead costs and allocated
service department costs are applied to products.
Production
Department
(Machining)
Production
Department
(Assembly)
The
Product
10-18
Distinguishing Between Support
Services & Production Departments
Production
departments
Support service
departments
Carry out the
goals of an organization
by providing goods and
services directly to customers.
Provide support that
facilitates the activities of
production departments.
10-19
Reasons for Allocating Service Costs
Required reporting:
Tax regulations
External financial
reporting
Cost-based contracts:
Government
Foundation
Private industry
To simulate an external
market for internal
services
Influencing Behavior:
Incentive to control the
use of support services
10-20
Cost Allocation from Service
Departments to Internal Customers
1. Identify the costs to be allocated
to internal customers.
2. Choose the appropriate allocation
base(s) and rate(s).
3. Select and use the cost-allocation
method.
4. Determine if the cost allocations
achieve the desired results - if
not, begin the process again.
10-21
Learning Objective 2
10-22
Identify the Costs to be Allocated to
Internal Customers
Cafeteria
Security
COST POOLS
Budgeted or actual
spending amounts
for distinct sets of
resources
Custodial
Personnel
Multiple cost pools facilitate managing the different
types of support services and should allow more
accurate cost allocations to internal customers.
Allocate only service department resources
used, not resources supplied.
10-23
Learning Objective 3
10-24
Choosing a Cost-Allocation Base
Labor
related
costs
Occupancy
related
costs
A cost driver is the
factor that causes or “drives”
an activity’s costs.
Machine
related
costs
Service
related
costs
10-25
Choosing a Cost-Allocation Base
Selection criteria
Causal
relation
A cost driver is the
factor that causes or “drives”
an activity’s costs.
Reasonableness
Benefits
received
10-26
Choosing a Cost-Allocation Base
Criteria for
selection
Where possible use ActivityBased Costing analysis to
select cost driver allocation
bases.
Examples
10-27
Choosing a Cost-Allocation Base
Category
Common Cost
Example
Supervision
Labor
related
Machine
related
Personnel services
Equipment insurance
Taxes on equipment
Equipment depreciation
Equipment maintenance
Typical Allocation Base
for Common Cost
Number of employees
Payroll dollars
Labor hours
Number of employees
Equipment value
Equipment value
Machine hours
Equipment cost
Number of machines
Machine hours
10-28
Choosing a Cost-Allocation Base
Common cost
Category
Example
Building rental
Building insurance
Occupancy
Heat & A/C
related
Concession rental
Service
related
Building Maintenance
Materials Handling
Laundry
Billing and accounting
Indirect materials
Cafeteria
Typical allocation base
for common cost
Space occupied
Space occupied
Space or volume occupied
Space occupied
Desirability of location
Space occupied
Quantity or value of materials
Weight of laundry processed
Number of documents
Value of direct materials
Number of meals
10-29
Learning Objective 4
10-30
Methods of Allocating Service
Department Costs
Problem
Allocating costs when service departments
provide services to each other
Solutions
Direct method
Step method
Reciprocal method
10-31
Direct Method
Cost of services
between service
departments are
ignored and all
costs are
allocated directly
to production
departments.
Service
department
(cafeteria)
Production
department
(machining)
Service
department
(custodial)
Production
department
(assembly)
10-32
Direct Method Example
Departmental costs
before allocation
Number of employees
Square feet occupied
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
15
5,000
$ 90,000
10
2,000
$ 400,000
20
25,000
$ 700,000
30
50,000
Service department
Allocation base
Cafeteria
Custodial
Number of employees
Square feet occupied
10-33
Direct Method Example
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
Departmental costs
before allocation
$ 360,000
$ 90,000
$ 400,000
$ 700,000
Cafeteria allocation
?
?
?
?
Custodial allocation
?
?
?
?
Total after allocation
?
?
?
?
10-34
Direct Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
(360,000)
0
144,000
?
Custodial allocation
?
?
?
?
Total after allocation
?
?
?
?
20
$360,000 ×
= $144,000
20 + 30
Allocation base: Number of employees
10-35
Direct Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
144,000
216,000
(360,000)
0
Custodial allocation
?
?
?
?
Total after allocation
?
?
?
?
$360,000 ×
30
= $216,000
20 + 30
Allocation base: Number of employees
10-36
Direct Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
144,000
216,000
(360,000)
Custodial allocation
Total after allocation
0
0
$
0
(90,000)
$
0
25,000
$90,000 ×
25,000 + 50,000
30,000
?
$ 574,000
?
= $30,000
Allocation base: Square feet occupied
10-37
Direct Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
144,000
216,000
30,000
60,000
$ 574,000
$ 976,000
(360,000)
Custodial allocation
Total after allocation
0
0
$
0
(90,000)
$
0
50,000
$90,000 ×
25,000 + 50,000
= $60,000
Allocation base: Square feet occupied
10-38
Step Method
Service department
costs are allocated
to other service
departments and
to production
departments, usually
starting with the
service department
that provides the
greatest amount of
service to other
departments.
Service
department
(cafeteria)
Production
department
(machining)
Service
department
(custodial)
Production
department
(assembly)
10-39
Step Method
Once a service
department’s costs
are allocated,
other service
department costs
are not allocated
back to it.
Service
department
(cafeteria)
Production
department
(machining)
Service
department
(custodial)
Production
department
(assembly)
10-40
Step Method
Custodial will
have a new
total to allocate
to production
departments: its
own costs plus
those costs
allocated from
the cafeteria.
Service
department
(cafeteria)
Production
department
(machining)
Service
department
(custodial)
Production
department
(assembly)
10-41
Step Method Example
We will use the same data used in the direct method example.
Departmental costs
before allocation
Number of employees
Square feet occupied
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
15
5,000
$ 90,000
10
2,000
$ 400,000
20
25,000
$ 700,000
30
50,000
Service Department
Allocation Base
Cafeteria
Custodial
Number of employees
Square feet occupied
10-42
Step Method Example
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
Departmental costs
before allocation
$ 360,000
$ 90,000
$ 400,000
$ 700,000
Cafeteria allocation
?
?
?
?
Custodial allocation
?
?
?
?
Total after allocation
?
?
?
?
10-43
Step Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
?
?
(360,000)
60,000
Custodial allocation
?
?
?
?
Total after allocation
?
?
?
?
10
$360,000 ×
10 + 20 + 30
= $60,000
Allocation base: Number of employees
10-44
Step Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
(360,000)
?
Custodial allocation
?
?
?
?
Total after allocation
?
?
?
?
20
$360,000 ×
10 + 20 + 30
= $120,000
Allocation base: Number of employees
10-45
Step Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(360,000)
Custodial allocation
?
?
?
?
Total after allocation
?
?
?
?
30
$360,000 ×
10 + 20 + 30
= $180,000
Allocation base: Number of employees
10-46
Step Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(360,000)
Custodial allocation
?
Total after allocation
?
(150,000)
$
0
?
?
?
?
New total = $90,000 original custodial cost
plus $60,000 allocated from the cafeteria.
10-47
Step Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(150,000)
50,000
?
$ 570,000
?
(360,000)
Custodial allocation
Total after allocation
$150,000 ×
0
$
0
$
0
25,000
25,000 + 50,000
= $50,000
Allocation base: Square feet occupied
10-48
Step Method Example
Departmental costs
before allocation
Cafeteria allocation
Service Departments
Production Departments
Cafeteria
Custodial
Machining
Assembly
$ 360,000
$ 90,000
$ 400,000
$ 700,000
60,000
120,000
180,000
(150,000)
50,000
100,000
$ 570,000
$ 980,000
(360,000)
Custodial allocation
Total after allocation
0
$
0
$
0
50,000
$150,000 ×
25,000 + 50,000
= $100,000
Allocation base: Square feet occupied
10-49
Comparison of Methods
Totals after allocation
Method
Direct
Step
Machining
Department
Assembly
Department
$
$
574,000
570,000
976,000
980,000
10-50
Learning Objective 5
10-51
Comparison of Methods
Cost Allocation Accuracy
The Direct method does not consider
interactions among service departments.
The Step method considers some interactions
among service departments.
ABC cost-driver bases should reflect causeand-effect relationship between resource
spending and use.
The Reciprocal method is more thorough in
considering interactions among service
departments. (Appendix A)
More
accurate but
also more
complex
and more
costly.
10-52
Determine if the Cost Allocations
Achieve Desired Results
COST ALLOCATION EFFECTS
If support-service departments provide significant services to each
other, the amounts of costs allocated to production
departments probably differ significantly under each method.
Significant
differences
can affect:
Performance
evaluations
Contracts
Decision
making
10-53
Determine if the Cost Allocations
Achieve Desired Results
Cost allocations may have unexpected
side effects. Common problems and
possible solutions are:
Problem
Solution
 Users overuse
Adjust allocation rates up
or down to get the desired
behavior by users.
services because per use
allocation is too low.
 Users underuse
services because per use
allocation is too high.
10-54
Determine if the Cost Allocations
Achieve Desired Results
Cost allocations may have unexpected
side effects. Common problems and
possible solutions are:
Problem
Solution
 Performance evaluations
 Remove allocations from
based on allocated service
department costs frustrate
managers as they have no
control over the incurrence
of costs in the service
department.
performance evaluations.
 Allocate budgeted
instead of actual service
department costs.
10-55
Determine if the Cost Allocations
Achieve Desired Results
COST ALLOCATION COSTS AND BENEFITS
Complex cost-allocation
systems are difficult
and costly to design.
Complex cost-allocation
systems are difficult
and costly to maintain.
Cost-allocation systems may require revision in a
continual process of improvement, which is costly but
can be justified if decisions and organizational
performance also continue to improve.
10-56
Ethical Role of Cost Allocations

Companies having both commercial and
government business may attempt to shift
overhead to the cost-plus government
business.


Each dollar of additional cost results in additional
revenue on the government work.
To avoid disputes, both parties should agree in
the contract precisely how common costs will
be allocated.
10-57
Learning Objective 6
10-58
Reciprocal Method

cafeteria

custodial

Appropriate for use when service
departments provide services to
each other
Allows simultaneous allocations of
cost between those service
departments
Uses matrix algebra to solve a set of
simultaneous equations
10-59
End of Chapter 10