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10Managing and
Allocating Support-Service Costs
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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.
Commercial firms -goods and services
(while earning a competitive profit)
Nonprofit hospitals -superior health care (while covering their costs of operation)
City governments -
limits)
City governments -essential services
to their citizens (within budgetary
limits)
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The Service-Cost Challenge
Achieving the goals of the organization requiresusing 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.
Needed:Reliable quantitative and
qualitative cost management information about relative costs and benefits of alternatives.
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Factors to be considered
Internal or Outsourced Support Services?
Are service providers reliable?
Is the functionstrategic to us?
Who has the
knowledge base?
Who has the more adequate
knowledge base?
How do the costs compare?
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Learning Objective 1
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Cost Allocation CostObject
Indirectcosts
Cost allocation is the process of assigningindirect costs to cost objects.
Indirect costs arecommon costs
of shared facilitiesor services.
Cost objects can be:•Departments benefiting
from services•Time periods when
services were provided
Managing Internal Support-Service Costs
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Do not charge internal customers
for support services and recover the
costs from general revenues.
Charge the cost of support services to using departments
and possibly recover the costs from these internal customers.
Managing Internal Support-Service Costs
Alternatives
Internal customersmay overuse a
free good.DISADVANTAGES
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Charge the cost of support services to using departments
and possibly recover the costs from these internal customers.
Managing Internal Support-Service Costs
Alternatives
DISADVANTAGES Allocations are arbitrary Rates subject to dispute May discourage use
Do not charge internal customers
for support services and recover the
costs from general revenue.
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But that would not bebeneficial to the company.What if we charged a flat
annual fee for the service?
My performance lookedgood until they
allocated those servicedepartment costs, soI’m not going to usethe service again.
Managing Internal Support-Service Costs
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That sounds better.If the fee is fixed,the more I use the
service the lower myaverage cost per
use will be.
Managing Internal Support-Service Costs
Is that really
what we want?
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First, we identify the activities that drive costs in each
service department.This cost driver is called
the allocation base.
How are servicedepartment costs
charged to productiondepartments?
Cost Allocation from Service Departments to Internal Customers
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Second, we measure theconsumption of the
allocation base in theproduction departments.
How are servicedepartment costs
charged to productiondepartments?
Cost Allocation from Service Departments to Internal Customers
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Third, we allocate the servicedepartment cost based onthe relative amount of the
allocation base used ineach production department.
How are servicedepartment costs
charged to productiondepartments?
Cost Allocation from Service Departments to Internal Customers
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The production department mightreimburse the service department,
but most likely the allocatedservice department costs
become a part of themanufacturing overhead in the production department.
What happens toservice departmentcosts after they are
allocated to productiondepartments?
Cost Allocation from Service Departments to Internal Customers
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I get it. They becomea part of the overhead
that is applied toproducts with apredeterminedoverhead rate.
That’s right. Take a look atthis flow chart.
I think it will summarizeour discussion of theallocation process.
Cost Allocation from Service Departments to Internal Customers
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First Stage AllocationsService department costs are
allocated to production departments.Service department(cafeteria)
Service department(accounting)
Service department(personnel)
Productiondepartment(machining)
Productiondepartment(assembly)
Theproduct
Cost Allocation from Service Departments to Internal Customers
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Service Department(Cafeteria)
Service Department(Accounting)
Service Department(Personnel)
ProductionDepartment(Machining)
ProductionDepartment(Assembly)
TheProduct
Second Stage AllocationsProducing department overhead costs and allocated
service department costs are applied to products.
Cost Allocation from Service Departments to Internal Customers
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Carry out the goals of an organizationby providing goods and
services directly to customers.
Provide support that facilitates the activities of production departments.
Productiondepartments
Support serviceSupport servicedepartments
Distinguishing Between Support Services & Production Departments
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Required reporting:Tax regulationsExternal financial reporting
Influencing Behavior:Incentive to control theuse of support services
Cost-based contracts:Government FoundationPrivate industry
Reasons for Allocating Service Costs
To simulate an external market for internal services
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1. Identify the costs to be allocatedto internal customers.
Cost Allocation from Service Departments to Internal Customers
2. Choose the appropriate allocation base(s) and rate(s).
allocation 3. Select and use the cost-allocation method.
4. Determine if the cost allocations achieve the desired results - if not, begin the process again.
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Learning Objective 2
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COST POOLSCOST POOLSBudgeted or actualspending amountsfor distinct sets of
resources
Multiple cost pools facilitate managing the different types of support services and should allow more accurate cost allocations to internal customers.
Identify the Costs to be Allocated to Internal Customers
Custodial
Personnel
Cafeteria
Security
Allocate only service department resourcesused, not resources supplied.
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Learning Objective 3
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A cost driver is thefactor that causes or “drives”
an activity’s costs.
Machinerelatedcosts
Laborrelatedcosts
Occupancyrelatedcosts
Servicerelatedcosts
Choosing a Cost-Allocation Base
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A cost driver is thefactor that causes or “drives”
an activity’s costs.
Selection criteria
Causalrelation
Benefitsreceived
Reasonableness
Choosing a Cost-Allocation Base
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Examples
Criteria forselection
Where possible use Activity-Based Costing analysis toselect cost driver allocationbases.
Choosing a Cost-Allocation Base
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Common Cost Typical Allocation BaseCategory Example for Common Cost
Supervision Number of employeesLabor Payroll dollars
related Labor hoursPersonnel services Number of employees
Equipment insurance Equipment valueTaxes on equipment Equipment value
Machine Equipment depreciation Machine hoursrelated Equipment cost
Equipment maintenance Number of machinesMachine hours
Choosing a Cost-Allocation Base
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Common cost Typical allocation baseCategory Example for common cost
Building rental Space occupiedBuilding insurance Space occupied
Occupancy Heat & A/C Space or volume occupiedrelated Concession rental Space occupied
Desirability of locationBuilding Maintenance Space occupied
Materials Handling Quantity or value of materialsService Laundry Weight of laundry processedrelated Billing and accounting Number of documents
Indirect materials Value of direct materialsCafeteria Number of meals
Choosing a Cost-Allocation Base
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Learning Objective 4
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Methods of Allocating Service Department Costs
ProblemAllocating costs when service departments
provide services to each other
SolutionsDirect methodStep method
Reciprocal method
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Direct Method
Service department(cafeteria)
Service department(custodial)
Productiondepartment(machining)
Productiondepartment(assembly)
Cost of servicesbetween servicedepartments areignored and all
costs areallocated directly
to productiondepartments.
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Direct Method Example
Service department Allocation base
Cafeteria Number of employeesCustodial Square feet occupied
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$ Number of employees 15 10 20 30 Square feet occupied 5,000 2,000 25,000 50,000
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Direct Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation ? ? ? ?
Custodial allocation ? ? ? ?
Total after allocation ? ? ? ?
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Direct Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 0 144,000 ?
Custodial allocation ? ? ? ?
Total after allocation ? ? ? ?
$360,000 ×20
20 + 30= $144,000
Allocation base: Number of employees
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Direct Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 0 144,000 216,000
Custodial allocation ? ? ? ?
Total after allocation ? ? ? ?
$360,000 ×30
20 + 30= $216,000
Allocation base: Number of employees
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Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 0 144,000 216,000
Custodial allocation 0 (90,000) 30,000 ?
Total after allocation $ 0 $ 0 574,000$ ?
Direct Method Example
$90,000 ×25,000
25,000 + 50,000= $30,000
Allocation base: Square feet occupied
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Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 0 144,000 216,000
Custodial allocation 0 (90,000) 30,000 60,000
Total after allocation $ 0 $ 0 574,000$ 976,000$
Direct Method Example
50,00025,000 + 50,000
= $60,000$90,000 ×
Allocation base: Square feet occupied
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Step Method
Service departmentcosts are allocated
to other servicedepartments and
to productiondepartments, usually
starting with theservice departmentthat provides the
greatest amount ofservice to otherdepartments.
Service department(cafeteria)
Service department(custodial)
Productiondepartment(machining)
Productiondepartment(assembly)
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Step Method
Service department(cafeteria)
Service department(custodial)
Productiondepartment(machining)
Productiondepartment(assembly)
Once a servicedepartment’s costs
are allocated, other service
department costsare not allocated
back to it.
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Step Method
Custodial willhave a new
total to allocateto production
departments: itsown costs plus
those costsallocated fromthe cafeteria.
Service department(cafeteria)
Service department(custodial)
Productiondepartment(machining)
Productiondepartment(assembly)
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Step Method Example
Service Department Allocation Base
Cafeteria Number of employeesCustodial Square feet occupied
We will use the same data used in the direct method example.
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$ Number of employees 15 10 20 30 Square feet occupied 5,000 2,000 25,000 50,000
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Step Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation ? ? ? ?
Custodial allocation ? ? ? ?
Total after allocation ? ? ? ?
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Step Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 60,000 ? ?
Custodial allocation ? ? ? ?
Total after allocation ? ? ? ?
$360,000 ×10
10 + 20 + 30= $60,000
Allocation base: Number of employees
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Step Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 60,000 120,000 ?
Custodial allocation ? ? ? ?
Total after allocation ? ? ? ?
$360,000 ×20
10 + 20 + 30= $120,000
Allocation base: Number of employees
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Step Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 60,000 120,000 180,000
Custodial allocation ? ? ? ?
Total after allocation ? ? ? ?
$360,000 ×30
10 + 20 + 30= $180,000
Allocation base: Number of employees
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Step Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 60,000 120,000 180,000
Custodial allocation ? (150,000) ? ?
Total after allocation ? $ 0 ? ?
New total = $90,000 original custodial costplus $60,000 allocated from the cafeteria.
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Step Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 60,000 120,000 180,000
Custodial allocation 0 (150,000) 50,000 ?
Total after allocation $ 0 $ 0 570,000$ ?
25,00025,000 + 50,000
= $50,000$150,000 ×
Allocation base: Square feet occupied
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Step Method Example
Service Departments Production Departments
Cafeteria Custodial Machining AssemblyDepartmental costs before allocation 360,000$ 90,000$ 400,000$ 700,000$
Cafeteria allocation (360,000) 60,000 120,000 180,000
Custodial allocation 0 (150,000) 50,000 100,000
Total after allocation $ 0 $ 0 570,000$ 980,000$
= $100,000$150,000 ×
Allocation base: Square feet occupied
50,00025,000 + 50,000
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Comparison of Methods
Totals after allocationMachining Assembly
Method Department DepartmentDirect 574,000$ 976,000$ Step 570,000 980,000
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Learning Objective 5
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Cost Allocation Accuracy
The Direct method does not consider interactions among service departments.
The Reciprocal method is more thorough in considering interactions among service
departments. (Appendix A)
ABC cost-driver bases should reflect cause-and-effect relationship between resource
spending and use.
Moreaccurate but
also morecomplexand more
costly.
The Step method considers some interactionsamong service departments.
Comparison of Methods
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COST ALLOCATION EFFECTS
If support-service departments provide significant services to eachother, the amounts of costs allocated to production
departments probably differ significantly under each method.
Significantdifferences can affect:
Contracts
Decisionmaking
Performanceevaluations
Determine if the Cost Allocations Achieve Desired Results
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Problem
Users overuse services because per use
allocation is too low.
Users underuse services because per use
allocation is too high.
Solution
Adjust allocation rates upor down to get the desired
behavior by users.
Determine if the Cost Allocations Achieve Desired Results
Cost allocations may have unexpected side effects. Common problems and
possible solutions are:
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Problem
Performance evaluations based on allocated service department costs frustrate managers as they have no control over the incurrence
of costs in the service department.
Solution
Remove allocations from performance evaluations.
Allocate budgeted instead of actual service
department costs.
Determine if the Cost Allocations Achieve Desired Results
Cost allocations may have unexpected side effects. Common problems and
possible solutions are:
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COST ALLOCATION COSTS AND BENEFITS
Complex cost-allocationsystems are difficultand costly to design.
Complex cost-allocationsystems 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.
Determine if the Cost Allocations Achieve Desired Results
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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.
Ethical Role of Cost Allocations
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Learning Objective 6
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Reciprocal Method
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
cafeteria
custodial