chapter 8 measuring and assigning support department...

Chapter 8: Measuring and Assigning Support Department Costs 77

Chapter 8Measuring and Assigning Support Department Costs

LEARNING OBJECTIVES

Chapter 8 addresses the following questions:

LO1 Define support departments, and explain why their costs are allocated to other departments.

LO2 Explain the process that is used to allocate support department costs.LO3 Explain how the direct method is used to allocate support costs to operating departments;

calculate cost allocations using the direct method.LO4 Explain how the step-down method is used to allocate support costs to operating

departments; calculate cost allocations using the step-down method.LO5 Explain how the reciprocal method is used to allocate support costs to operating

departments; calculate cost allocations using the reciprocal method.LO6 Explain the difference between single-and dual-rate allocations.LO7 Identify how support cost allocations and information quality impact management

decision-making.

These learning questions (LO1 through LO7) are cross-referenced in the textbook to individual exercises and problems.

© 2012 John Wiley and Sons Canada, Ltd.

78 Cost Management

QUESTIONS

8.1 Similarities: • All of the methods allocate support department costs to operating

departments• All of the methods rely on allocation bases to assign costs of support

departments to operating departments.• All of the methods result in a total allocated cost per unit• All of the methods use cost pools, and those are usually departments.

Differences:• Direct method ignores all interactions among support departments.• The step-down method takes into account some of the interactions

among support departments.• The reciprocal method takes into account all of the interactions among

support departments.

8.2 Support department costs are direct costs of the department, but indirect costs when allocated to other departments. Manufacturing overhead is a direct cost of the production process but it becomes an indirect cost when it is allocated to units.

8.3 Management's objectives should be the determining factor, tempered by the availability of the data and the cost of performing the allocation. For example, if the primary purpose is cost control, a method that recognizes interdepartmental relationships is appropriate. If the firm has a computer and appropriate software, the reciprocal allocation method is preferred. If the primary purpose is product costing and the firm has a manual system, the direct method may be preferred.

Following are other factors to consider in choosing an appropriate allocation method:• As the number of cost pools increase, calculations become more complex under

the reciprocal method,• When there are four or more support cost pools, software is needed to perform the

reciprocal method calculations• The degree of interaction among support departments; fewer interactions result in

fewer differences in allocation amounts

8.4 Costs that include support department allocations using a single cost pool and single allocation base for both fixed and variable costs would overstate the incremental costs used in short-term decisions. This limits the use of these costs for decision-making. However, when a dual rate system is developed, the variable costs are more likely to be relevant information for short-term decision-making.



8.5 Following are factors to consider in choosing an allocation base• Costs and benefits of the information gathered• Does one of the bases better reflect the use of the support department resources?• Will the allocation base be easy to measure and apply?• Are data available for the allocation base? How accurate are the data?

8.6 Department 1 is an operating department because it works directly on the firm's final product.

8.7 Operating departments manufacture goods or produce services that are sold to customers. Support departments interact primarily with operating departments and other support departments, and not with outside customers. Support departments provide operating departments with internal services such as accounting, research and development, maintenance, and so on.

8.8 The dual rate separates fixed and variable support costs. When this is done, the variable rate can be used as information for making decisions that require incremental costs, such as transfer prices and insource and outsource decisions. A single rate includes both fixed and variable costs and cannot be used for any type of decision making. Another advantage of the dual rate method is that the allocations more accurately represent the flow of resources because fixed and variable costs are separated and usually allocated using different allocation bases or actual usage of some sort.

8.9 Several problems can arise when allocated costs are used to charge for support services. Relevant support costs are often difficult to measure, so the allocations are often used instead of relevant cost analysis. Support cost allocations also tend to be inaccurate when measuring relevant costs for operating department decisions. Transfer prices are frequently used to charge user departments for the cost of support services, however these prices are often based on fully allocated costs and therefore include fixed support department costs as well as allocations from other support departments. As a result the transfer prices can be high, which can encourage user departments to outsource the support services. Support cost allocations are subject to the same uncertainties as other types of cost allocations. The process of measuring and allocating support costs is uncertain and requires judgment. Allocated support cost information can be low quality.

8.10 Because they include fixed costs and costs allocated from other departments, support department allocations result in high charges for services. Because they are high, sub-optimal behavior occurs, such as managers duplicating services either by purchasing them from outside the organization or providing them in their own departments. Often support departments are then underused, but the organization still incurs their costs. In addition, extra costs are incurred because internal services are duplicated.

8.11 Better short-term decisions would be made using the dual rate method because the variable costs of the support departments would be easy to use in decision-making. It would depend on the type of long term decision being made whether either method would provide useful information.


80 Cost Management

8.12 Estimated (budgeted) cost rates provide information for managers to use in budgeting and some of their decision-making. Managers can predict charges as they use the service. In addition, each department’s charges are not affected by other departments’ use of service. A disadvantage of budgeted rates is that user departments have little incentive to use resources efficiently because their charge is already known, and will not change with usage, if it is based on a fixed rate.

8.13 Accounting department costs could be allocated using number of employees, departmental direct costs, or time spent on activities for individual departments. An advantage of number of employees is that it would be simple to use in calculations. A disadvantage is that it probably does not reflect the use of the department by other departments. An advantage of departmental direct costs is that accounting activities probably increase as direct costs increase, and direct costs are fairly easy to measure. A disadvantage is that there are some accounting activities that do not vary with direct costs. And advantage of time spent on accounting activities for every department is that it is probably most accurately reflects the use of accounting by other departments, but it would be hard to track, and there is likely measurement error when time is not recorded as used, but estimated or recorded after the fact.

8.14a. GAAP requires manufacturing overhead to be allocated to units of product or service,

generally using a traditional cost accounting method such as job costing or process costing.

b. Under GAAP, costs for departments that directly support the manufacturing function, such as material handling are allocated. However, costs of departments that provide non-manufacturing support, such as accounting and human resources are not allocated to units or services, they are expensed as period costs.

8.15 If allocations are used as part of a planning activity, such as estimating budgets, then estimated costs should be used to incorporate any expected cost changes. If managers want to understand the actual use of support department resources, then actual values are used. If allocations of cost to departments are based on estimated volumes, then managers have little incentive to use resources efficiently because the estimate amount is set. However, if actual values are used, managers are penalized by higher allocations when one or more departments use less of the support department resources than expected.

8.16 A cafeteria in a university can be both a support department and a revenue-generating department. However, the type of department depends on whether the university subsidizes employee meals. If employees pay the full cost of meals, then the cafeteria it is a revenue-generating department. If an employee discount is given, but employees pay only part of the cost, and studetns also use the cafeteria, it is both a revenue-generating and a support department.



MULTIPLE CHOICE QUESTIONS

8.17 A business uses the step-down method to allocate service department costs to the manufacturingdepartments. Assume that there are two service departments and two manufacturing departments,as shown here:

Service Departments Manufacturing DepartmentsPlant Administration Custodial Services Cutting Polishing

Costs $360,000 $90,000 $261,000 $689,000Labour hours 25,000 6,000 18,000 30,000Space occupied (m2) 10,000 1,000 5,000 45,000

Plant administration costs are allocated based on labour hours, and custodial services costs areallocated based on space occupied. The total costs of the cutting and polishing departments(rounded to the closest 1,000), after allocating all the service department costs, starting withthe largest service provider, are:

a) Cutting, $396,000, and polishing, $914,000b) Cutting, $405,000, and polishing, $995,000c) Cutting, $381,000, and polishing, $889,000d) Cutting, $394,000, and polishing, $1,006,000e) Cutting, $380,000, and polishing, $892,000

Ans: D 1st Plant Administration is allocated to Custodial Services $40,000 (6,000/54,000*$360,000), Cutting $120,000 (18,000/54,000*$360,000) and Polishing $200,000 (30,000/54,000*$360,000); 2nd Custodial Services new balance of $130,000($90,000+$40,000) is allocated to Cutting $13,000 (5,000/50,000*$130,000) and Polishing $117,000 (45,000/50,000*$130,000)

8.18 The managers of ACME Manufacturing are discussing ways to allocate the cost of service departments,such as quality control and maintenance, to the production departments. To aid themin this discussion, the controller has provided the following information:

Quality Control Maintenance Machining Assembly TotalBudgeted overhead costs beforeAllocation $350,000 $200,000 $400,000 $300,000 $1,250,000Budgeted machine hours — — 50,000 — 50,000Budgeted direct labour hours — — — 25,000 25,000Budgeted hours of service:Quality control — 7,000 21,000 7,000 35,000Maintenance 10,000 — 18,000 12,000 40,000

Using the direct allocation method, the total amount of overhead allocated to each machine hour would be:a) $9.35b) $5.25c) $2.40d) $8.00e) $15.65


82 Cost Management

Ans: E Quality Control is allocated to Machining $262,500 (21,000/28,000*$350,000) and Assembly $87,500 (7,000/28,000*$350,000); Maintenance is allocated to Machining $120,000 (18,000/30,000*$200,000) and Assembly $80,000 (12,000/30,000*$200,000); total Machining costs ($400,000 + $262,500 + $120,000)/ 50,000 = $15.65

8.19 Which of the following methods of allocating service department costs results in the most accurateproduct cost?a) Direct methodb) Step-down methodc) Reciprocal method

d) Activity-based costing method

Ans: C

8.20 Which service department should be allocated first, using the step-down method of allocation?a) Department Ab) Department Bc) Department Cd) Department X or Y

Ans: A

8.21 Assume that the service departments’ costs were allocated in alphabetical order. What is the approximate overhead rate for Department C?a) $1,860b) $2,308c) $2,429

d) $2,516

Ans: D Department A allocated $5,714 ($800,000*500/70,000) to Department C and $13,714 ($800,000*1,200/70,000) to Department B. Department B allocated $14,429 [($650,000+$13,714) *1,000/46,000); Department C approximate overhead rate is ($400,000 + $5,714 + $14,429)/(147+20) = $2,516



EXERCISES

8.22 Estimated versus Actual Allocation Rates

A. Estimated costs = $40,000 + $12(5,000) = $100,000

Estimated allocation rate = $100,000/5,000 hours = $20/hour

B. Estimated cost at actual output = $40,000 + $12(4,900) = $98,800

Actual rate = $98,800/4,900 hours = $20.1633/hour

C. An advantage of using an estimated allocation rate is that managers know in advance what their costs will be. A disadvantage is that there is no incentive to use custodial hours wisely because the costrate is known and will not change during the period.

An advantage for using an actual allocation rate is that managers have a better idea about the effects of their use of custodial services on costs. A disadvantage is that they do not know their costs ahead of time, and they may have little control over whether the rate is higher or lower than expected.

8.23 Allocating Support Costs to Units

Monthly occupancy = 120 beds*0.8*30 days = 2,880 patient daysMonthly costs = $240,000 + $90*2,880 = $499,200Average daily charge = $499,200/2,880 = $173.33

8.24 Direct Method – Cedar Hill Manufacturing

A. Using the direct method:

a. From Administration:

To Cutting: $160,000 x (30,000/80,000) = $60,000

To Assembly: $160,000 x (50,000/80,000) = $100,000

b. From Custodial Services:

To Cutting: $100,000 x (20,000/50,000) = $40,000

To Assembly: $100,000 x (30,000/50,000) = $60,000


84 Cost Management

B. Calculate the total costs:

Cutting AssemblyDirect Costs $345,000 $731,000Allocated Costs: Administration 60,000 100,000 Custodial 40,000 60,000Total Costs $445,000 $891,000

C. Calculate cost per unit:

Cutting AssemblyTotal Costs $445,000 $891,000# units produced 50,000 90,000Cost per unit $8.90 $9.90

8.25 Step-Down method– Cedar Hill Manufacturing

A. Using the step-down method:

a. From Administration:To Custodial Services: $160,000 x (10,000/90,000) = $17,777.78To Cutting: $160,000 x (30,000/90,000) = $53,333.33To Assembly: $160,000 x (50,000/90,000) = $88,888.89

b. From Custodial Services:Custodial Services costs: $100,000 + $17,777.78 = $117,777.78To Cutting: $117,777.78 x (20,000/50,000) = $47,111.11To Assembly: $117,777.78 x (30,000/50,000) = $70,666.67

B. Calculate the total costs:

Cutting AssemblyDirect Costs $345,000 $731,000Allocated Costs: Administration 53,333.33 88,888.89 Custodial 47,111.11 70,666.67Total Costs $445,444.44 $890,555.56

C. Calculate cost per unit:

Cutting AssemblyTotal Costs $445,444.44 $890,555,56# units produced 50,000 90,000



Cost per unit $8.91 $9.90

8.26 Direct Method – Staffordshire Brothers

From Payroll/Tax Reporting Services:To Pet Store: $60,000 x (5/12) = $25,000To Pet Grooming: $60,000 x (7/12) = $35,000

From Custodial Services:To Pet Store: $40,000 x (3,000/8,000) = $15,000To Pet Grooming: $40,000 x (5,000/8,000) = $25,000

Pet Store Pet GroomingDirect Costs $72,000 $90,000Allocated Costs: Payroll/Tax Reporting 25,000 35,000 Custodial Services 15,000 25,000Total Costs $112,000 $150,000÷ 12 months per year $9,333 $12,500

8.27 Step-Down Method – Staffordshire Brothers

A. From Payroll/Tax Reporting Services:To Custodial: $60,000 x (3/15) = $12,000To Pet Store: $60,000 x (5/15) = $20,000To Pet Grooming: $60,000 x (7/15) = $28,000

Custodial costs: $40,000 + $12,000 = $52,000

From Custodial Services:To Pet Store: $52,000 x (3,000/8,000) = $19,500To Pet Grooming: $52,000 x (5,000/8,000) = $32,500

Pet Store Pet GroomingDirect Costs $72,000 $90,000Allocated Costs: Payroll/Tax Reporting Services 20,000 28,000 Custodial Services 19,500 32,500Total Costs $111,500 $150,500Monthly costs $9,291.67 $12,541.67

B. From Custodial Services:To Payroll/Tax Reporting: $40,000 x (1,000/9,000) = $4,444.44To Pet Store: $40,000 x (3,000/9,000) = $13,333.33To Pet Grooming: $40,000 x (5,000/9,000) = $22,222.22

Payroll/Tax Reporting Services costs: $60,000 + $4,444.44 = $64,444.44

From Payroll/Tax Reporting Services:


86 Cost Management

To Pet Store: $64,444.44 x (5/12) = $26,851.85To Pet Grooming: $64,444.44 x (7/12) = $37,592.59

Pet Store Pet GroomingDirect Costs $72,000 $90,000Allocated Costs: Payroll/Tax Reporting Services 13,333.33 22,222.22 Custodial Services 26,851.85 37,592.59Total Costs $112,185.18 $149,814.81Monthly costs $9,348.77 $12,484.57

8.28 Direct and Step-Down Methods – Donaldson Company

Direct Allocation Method:

Step-Down Allocation Method:

8.29 Single-Rate versus Dual-Rate

A. First, use the cost function to calculate total cafeteria costs for July:Total cafeteria costs = $12,000 + [$2.50 × (3,200+1,000)] = $22,500



Second, determine the single-rate allocation per meal:Single-rate allocation per meal = $22,500 / (3,200+1,000) = $5.3571 per meal

Finally, allocate costs using the direct method:Allocation to administration (3,200 meals × $5.3571) $17,143Allocation to factory (1,000 meals × $5.3571) 5,357

Total cost allocated $22,500

B. First, determine the fixed and variable allocation rates:Fixed cost allocation rate = $12,000/(3,200+1,000) = $2.8571 per mealVariable cost allocation rate (given) = $2.50 per meal

Allocations to administration:Fixed (3,200 × $2.8571) $9,143Variable (3,200 × $2.50) 8,000 $17,143

Allocation to factory:Fixed (1,000 × $2.8571) $2,857Variable (1,000 × $2.50) 2,500 5,357

Total cost allocated $22,500

Notice that the costs allocated in Part B are the same as in Part A. This result occurred ONLY because the same allocation base (actual number of meals) was used to allocate both fixed and variable costs. Under the dual-rate method, different allocation bases are often used for fixed and variable costs. However, even if the same allocation base is used, the dual-rate method provides managers with separate rates for fixed and variable costs, which can be useful for decision making. Alternatively, estimated volume of the allocation base may be used for fixed costs, while actual volume of the allocation base is used for variable costs. See Part E, below.

C. Pros for the single rate method:• It is simple to calculate.• It provides the same result as the dual-rate method in cases where the same

allocation base is identified for both fixed and variable costs.

Cons for the single rate method:• Because fixed and variable costs are combined, the cost rate does not provide

managers with an estimate of incremental costs for decision making.

D. For this company, because actual meals were used as the allocation base for both methods, there is no difference. If a different allocation base such as the number of employees had been used for the fixed costs, then the methods would have resulted in a more favorable allocation for one of the departments. In general, a department would prefer the method that is considered to be fairer or that allocates a smaller cost to the department.


88 Cost Management

E. Because the company was closed for retooling in July and far fewer meals were served than usual, the cost allocation to administration would be considerably higher than usual. In other words, the fixed costs would be spread over a smaller than usual number of meals served, leading to a higher fixed cost rate than normal. It would be fairer to the administration department to allocate costs based on either the average number of employees or the typical number of meals served rather than based on actual meals served during July. The additional fixed costs that would normally be allocated to the factory could be assigned to general overhead.

8.30 Stand-Alone and Incremental Cost Methods, Fairness

A. Stand-alone method, based on the cost of separate travel to each school:

State University:Allocation percent ($400/$1,400) 28.57%Allocated cost (28.57% × $864) $246.86

City College:Allocation percent ($200/$1,400) 14.29%Allocated cost (14.29% × $864) 123.43

Private University:Allocation percent ($800/$1,400) 57 .14 %Allocated cost (57.14% × $864) 493 .71

Totals 100 .00 % $864 .00

B. Incremental method, using number of days to determine degree of responsibility and using actual cost for separate travel:

Most responsible is State University, at 3 days of travel time $400.00Next most responsible is Private University, at 2 days ($864 – $400) 464.00Least responsible is city College, at 1 day ($864 – $400 – $464) 0 .00

Total $864 .00

Alternatively, degree of responsibility could be based on the relative cost of traveling separately to each school:

Most responsible is Private University at cost of $800 $800.00Next most responsible is State University at cost of $400: (864 – $800) 64.00Least responsible is City College, at cost of $200: ($864 – $800 – $64)) 0 .00

Total $864 .00

C. The stand-alone method is most fair in this situation. It does not seem fair that City College pays no travel costs under the two versions of the incremental method. Also, it does not seem fair that the cost allocated to Private University and State University should vary widely depending on how the degree of responsibility is determined.



8.31 Single-Rate versus Dual-Rate, Estimated and Actual Volumes

A. Allocation of housekeeping costs using the single-rate method:

Single rate based on estimated hours:Fixed costs: $40,000/5,000 hours $ 8.00 per hourVariable costs 12 .00 per hour

Single rate $20 .00 per hour

The single rate could also be calculated by first estimating the total housekeeping costs per month, and then dividing by estimated hours:

Total costs [$40,000 + (5,000 hours × $12.00 per hour)] $100,000Estimated hours ÷ 5,000

Single rate $20 .00 per hour

Allocations based on estimated hours:Department A (1,600 hours × $20) $ 32,000Department B (1,400 hours × $20) 28,000Department C (2,000 hours × $20) 40,000

Total $100,000

B. For the dual-rate method, see the calculations in Part A for the fixed and variable cost rates per hour. The following dual-rate allocations are based on estimated hours for fixed costs and actual hours for variable costs.

Department A: (1,600 estimated hrs × $8) + (1,500 actual hrs × $12) $30,800Department B: (1,400 estimated hrs × $8) + (1,600 actual hrs × $12) 30,400Department C: (2,000 estimated hrs × $8) + (1,800 actual hrs × $12) 37,600

Total $98,800

Notice that the total cost allocated of $98,800 is not equal to the estimated cost of $100,000 (see Part A). The difference arises because variable costs are allocated based on actual instead of estimated hours. Because total variable costs are expected to vary based on actual number of hours, total actual costs are expected to be different than total estimated costs.

C. Below are a number of advantages and disadvantages. Students may think of others.

Advantages of single-rate method with allocation based on estimated volume:• The single-rate method does not require accurate estimation of the cost function

for support services.• The single-rate method involves simpler calculations.• Using estimated rates and estimated hours helps managers plan departmental

costs because they know ahead of time what the total cost will be.© 2012 John Wiley and Sons Canada, Ltd.

90 Cost Management

Disadvantages of single-rate method with allocation based on estimated volume:• Managers may overuse support resources because their charges are at a fixed

amount that will not change with the volume of resources used.• Support cost allocations may be unfair to managers who accurately estimate their

use of support services.• Support department managers may have difficulty planning operations because

user departments have an incentive to underestimate resource use.

Advantages of dual-rate method with allocation based on estimated volume for fixed costs and actual volume for variable costs:

• Using estimated rate and estimated hours for fixed support costs helps managers plan departmental costs because the allocation will not be affected by the volume of resources used by all of the user departments.

• Using actual volume for variable costs most accurately holds departments responsible for the use of resources, discouraging managers from overusing support services.

• Because they will be charged fixed costs based on estimated volume, department managers are encouraged to accurately estimate their use of support services. In turn, more accurate estimates improve planning in the support departments.

Disadvantage of dual-rate method with allocation based on estimated volume for fixed costs and actual volume for variable costs:

• Department managers who improve their efficiency in the use of support services will still be allocated the estimated amount for fixed resources.

• Allocations to user departments may be unfair if the cost function for the support department is estimated inaccurately.

8.32 Direct Method Using Estimated Costs, Benchmarking - Devon

A.Direct method allocation using direct labour hours:

Support Departments Operating DepartmentsDept. A Dept. B Dept. C Casting Machining Total

Allocation Base:Direct labour hours 6,000 4,000 10,000

60% 40% 100%Costs:

Direct costs $88,000 $63,000 $40,000 $191,000Department A (88,000) $ 52,800 $35,200 0Department B (63,000) 37,800 25,200 0Department C (40,000) 24,000 16,000 0

Total allocated cost $ 0 $ 0 $ 0 $114,600 $76,400 $191,000



Direct method allocation using costs to purchase outside:Support Departments Operating Departments

Dept. A Dept. B Dept. C Casting Machining TotalAllocation Bases:

Department A outside costs $50,000 $60,000 $110,00045.45% 54.55% 100%

Department B outside costs $40,000 $20,000 $60,00066.67% 33.33% 100%

Department C outside costs $30,000 $30,000 $50,00050.00% 50.00% 100%

Costs:Direct costs $88,000 $63,000 $40,000 $191,000Department A (88,000) $40,000 $48,000 0Department B (63,000) 42,000 21,000 0Department C (40,000) 20,000 20,000 0

Total allocated cost $ 0 $ 0 $ 0 $102,000 $89,000 $191,000

B. Devon could use the cost of purchasing outside as a benchmark for both departments, but there are some advantages and disadvantages. Using the direct method, no interactions of support department services are reflected. This might understate the cost of services. However, fixed costs are included, and many of these may be sunk costs, for example depreciation expense. These could overstate the support department costs. If the costs for internal and external support services are similar, the cost to purchase outside might provide a good benchmark if it is equal to or less than the cost of internally providing the support. However, if the outside cost is more, incentive exists for increasing both the cost and use of services, which may be inefficient for the company overall. Alternatively, if the outside cost is much less, departments may begin to outsource the services and this duplicates services and may be inefficient for the overall company as well.

8.33 Direct and Step-Down Methods with Dual Rates - Petro-X

A. Direct Method Allocation

Support Departments Operating DepartmentsPhysical Equipment

Plant Maintenance Dept. X Dept. Y TotalFixed Cost Allocation:Allocation bases:

Square metres 5,000 8,000 13,00038.462% 61.538% 100.00%

Machine hours 10,000 15,000 25,00040.00% 60.00% 100.00%

Fixed costs: $39,000 $75,000 $114,000Physical plant (39,000) $15,000 $ 24,000 0Equipment maintenance (75,000) 30,000 45,000 0

Allocated fixed cost 0 0 45,000 69,000 114,000


92 Cost Management

Variable Cost Allocation:Allocation bases:

# of employees 40 50 9044.444% 55.556% 100.00%

Maintenance hours 200 400 60033.333% 66.667% 100.00%

Variable costs: 18,000 60,000 78,000Physical plant (18,000) 8,000 10,000 0Equipment maintenance (60,000) 20,000 40,000 0

Allocated variable cost 0 0 28,000 50,000 78,000

Total allocated cost(fixed + variable) $ 0 $ 0 $73,000 $119,000 $192,000

B. Step-down method allocation, with physical plant costs allocated first



Square metres 3,900 5,000 8,000 16,90023.077% 29.586% 47.337% 100.00%

Machine hours 10,000 15,000 25,00040% 60% 100.00%

Fixed costs: $39,000 $75,000 $114,000Step 1: Physical plant (39,000) 9,000 $11,538 $ 18,462 0Step 2: Equip. maint. (84,000) 33,600 50,400 0



# of employees 12 40 50 10211.76% 39.22% 49.02% 100.00%

Maintenance hours 200 400 60033.333% 66.667% 100.00%

Variable costs: 18,000 60,000 78,000Step 1: Physical plant (18,000) 2,118 7,059 8,823 0Step 2: Equip. maint. (62,118) 20,706 41,412 0





C. Step-down method allocation, with equipment maintenance costs allocated first



Machine hours 0 10,000 15,000 25,0000.00% 40% 60% 100.00%

Square metres 5,000 8,000 13,00038.462% 61.538% 100.00%

Fixed costs: $39,000 $75,000 $114,000Step 1: Equip. maint. 0 (75,000) $30,000 $ 45,000 0Step 2: Physical plant (39,000) 15,000 24,000 0



Maintenance hours 10 200 400 6101.639% 32.787% 65.574% 100.00%

# of employees 40 50 9044.44% 55.56% 100.00%

Variable costs: 18,000 60,000 78,000Step 1: Equip. maint. 984 (60,000) 19,672 39,344 0Step 2: Physical plant (18,984) 0 8,437 10,547 0



D. Ideally, departments should be allocated in the order their services are used, with departments providing more services to other departments according to their rank of services provided. Because services can be difficult to measure, direct costs are often used as a measure of services provided.


94 Cost Management

8.34 Reciprocal Method - Brown and Brinkley Brokerage

A sample spreadsheet using Excel Solver for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). Below are manual calculations.

Manual Calculations using Simultaneous Equations:

Support Departments Operating DepartmentsResearch Administration Institutional Retail Total

Allocation Bases:Research hours 200 500 300 1,000

20% 50% 30% 100%Number of employees 7 8 10 25

28% 32% 40% 100.00%

Department costs:Payroll costs $350,000 $300,000 $400,000 $550,000 $1,600,000Other costs 230,000 150,000 120,000 240,000 740,000

Total department costs $580,000 $450,000 $520,000 $790,000 $2,340,000

Given the above calculations, create simultaneous equations for the support costs:

Research = $580,000 + 28% * Administration

Administration = $450,000 + 20% * Research

Set the two equations equal to each other and solve for the fully allocated cost of one support department:

Research = $580,000 + 28% * ($450,000 + 20% * Research)Research = $580,000 + $126,000 + 5.6% * Research94.4% * Research = $706,000Research = $706,000/94.4% = $747,881

Then solve for the fully allocated cost of the other support department:

Administration = $450,000 + 20% * Research= $450,000 + 20% * $747,881= $450,000 + $149,576= $599,576



Finally, allocate the full cost of each support department to all departments:

Support Departments Operating DepartmentsResearch Administration Institutional Retail Total

Allocation Bases:Research hours 200 500 300 1,000

20% 50% 30% 100%Number of employees 7 8 10 25

28% 32% 40% 100.00%

Total department costs $580,000 $450,000 $ 520,000 $ 790,000 $2,340,000Cost allocations:

Research (747,881) 149,576 373,941 224,364 0Administration 167,881 (599,576) 191,864 239,831 0

Total allocated costs $ 0 $ 0 $1,085,805 $1,254,195 $2,340,000

8.35 Reciprocal Method - Paul’s Valley Protection Service

A sample spreadsheet using Solver for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). Below are manual calculations.

Manual Calculations using Simultaneous Equations:

Let S1, S2 and S3 represent the full cost of providing each department's service. The simultaneous equations for support department costs are:

S1 = $30,000 + 0.1*S2 + 0.2*S3S2 = $20,000 + 0.4*S1 + 0.2*S3S3 = $40,000 + 0.1*S1 + 0.2*S2

Substitute S1 into the equation for S2 and solve for S2:

S2 = $20,000 + 0.4($30,000 + 0.1*S2 + 0.2*S3) + 0.2*S3S2 = $20,000 + $12,000 + 0.04*S2 + 0.08*S3 + 0.2*S3S2 = $32,000 + 0.04*S2 + 0.28*S30.96*S2 = $32,000 + 0.28*S3S2 = ($32,000/0.96) + (0.28/0.96)*S3S2 = $33,333.33 + 0.291667*S3

Substitute S1 into the equation for S3:

S3 = $40,000 + 0.1($30,000 + 0.1*S2 + 0.2*S3) + 0.2*S2S3 = $40,000 + $3,000 + 0.01*S2 + 0.02*S3 + 0.20*S2S3 = $43,000 + 0.21*S2 + 0.02*S30.98*S3 = $43,000 + 0.21*S2


96 Cost Management

Substitute S2 into the equation for S3 and solve for S3:

0.98*S3 = $43,000 + 0.21($33,333.33 + 0.291667*S3)0.98*S3 = $43,000 + $7,000 + 0.0613*S30.91875*S3 = $50,000S3 = $54,422

Substitute S3 back into the equation for S2 and solve for S2:

S2 = $33,333.33 + 0.291667*$54,422S2 = $49,206

Substitute S2 and S3 back into the equation for S1 and solve for S1:

S1 = $30,000 + 0.1*$49,206 + 0.2*$54,422 S1 = $45,805

Finally, support costs are allocated to all of the departments:

Support Departments Operating DepartmentsS1 S2 S3 P1 P2 P3 Total

S1 40% 10% 20% 20% 10% 100%S2 10% 20% 20% 50% 100%S3 20% 20% 10% 40% 10% 100%

Department Costs $30,000 $20,000 $40,000 $90,000Cost Allocations:

S1 (45,805) 18,322 4,581 $ 9,161 $ 9,161 $ 4,581 $ 0S2 4,921 (49,206) 9,841 9,841 0 24,603 0S3 10,884 10,884 (54,422) 5,442 21,769 5,442 0

Total Allocated Cost $ 0 $ 0 $ 0 $24,444 $30,930 $34,625 $90,000

8.36 Step-Down, Direct, and Reciprocal Methods, Accuracy of Allocation - Software Plus Corporation

A sample spreadsheet showing the calculations for this problem under the direct, step-down, and reciprocal methods is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. Software Plus has been using the step-down method that reflects half of the support department interactions. The costs of support departments are allocated one at a time. Once the costs of a particular support department are allocated, that department does not receive allocations from the remaining support departments.

B. The direct method ignores all of the support department interactions. The costs of all support departments are allocated directly to operating departments. No support department costs are allocated to other support departments.



C. The reciprocal method uses all of the support department interactions. The costs of support departments are allocated simultaneously to each other, and then support department costs are allocated to operating departments.

D. The following solution for the step-down method allocates the costs of Information Systems first. This department was chosen because it is largest with respect to direct support department costs. The costs of Information Systems are allocated to the other departments based on the percentages given in the problem.

Administration is the next largest support department, so it is allocated second. When reviewing the allocation for Administration, remember that Information Systems is now out of the allocation, so the allocation percentages need to be adjusted. The percentage of Administration service remaining is (100%-50%), or 50%. To allocate Administration’s cost to Maintenance, divide 10% by 50%, so Maintenance receives 1/5, or 20% of Administration cost. Also note that the total cost allocated for Administration is $50,000, which is equal to the direct cost of $40,000 plus the $10,000 allocated from Information Systems.

The final support department allocated is Maintenance. Because costs for all other support departments have already been allocated, Maintenance costs are allocated only to the operating departments. The total cost allocated is $34,000, which is the sum of Maintenance direct costs ($20,000) plus the costs allocated from Information Systems ($2,500) and Administration ($11,500).

Support Departments Operating DepartmentsAdmin. Maint. Info.Sys. Games Simulation Total

Allocation Percentages:Step 1: Information Systems 35% 5% — 40% 20% 100%Step 2: Administration — 10%/50% — 10%/50% 30%/50% 100%Step 3: Maintenance — — — 40%/70% 30%/70% 100%

Direct Support Costs $40,000 $20,000 $50,000 $110,000Allocations:

Step 1: Information Systems 17,500 2,500 (50,000) 20,000 10,000 0Step 2: Administration (57,500) 11,500 0 11,500 34,500 0Step 3: Maintenance 0 (34,000) 0 19,429 14,571 0

Total Allocated Costs $ 0 $ 0 $ 0 $50,929 $59,071 $110,000

E. When Administration is allocated using the direct method, only the percentages from Games and Simulations departments are used. So, Games receives 10%/(10%+30%) ,or 1/4 of Administration’s cost, and Simulations receives the remaining 3/4 of cost. For the allocation of Maintenance, 40%/(40%+30%), or 57.143% goes to Games and the remaining 42.857% goes to Simulations. Information Systems costs are allocated in a similar manner.


98 Cost Management


Allocation Percentages:Administration 10%/40% 30%/40% 100%Maintenance 40%/70% 30%/70% 100%Information Systems 40%/60% 20%/60% 100%

Direct Support Costs $40,000 $20,000 $50,000 $110,000Allocations: Administration (40,000) 0 0 $10,000 $30,000 0 Maintenance 0 (20,000) 0 11,429 8,571 0

Information Systems 0 0 (50,000) 33,333 16,667 0Total Allocated Costs $ 0 $ 0 $ 0 $54,762 $55,238 $110,000

F. Below is the solution under the reciprocal method. This solution was obtained using Solver with the following simultaneous equations:

Admin = $40,000 + 20%Maint + 35%InfoMaint = $20,000 + 10%Admin + 5%InfoInfo = $50,000 + 50%Admin + 10%Maint


Use of Services:Administration — 10% 50% 10% 30% 100%Maintenance 20% — 10% 40% 30% 100%Information Systems 35% 5% — 40% 20% 100%

Direct Support Costs $40,000 $20,000 $50,000 $110,000Allocations:

Administration (78,964) 7,896 39,482 7,896 23,689 0Maintenance 6,507 (32,533) 3,253 13,013 9,760 0Information Systems 32,457 4,637 (92,735) 37,094 18,547 0

Total Allocated Costs $ 0 $ 0 $ 0 $58,004 $51,996 $110,000

G. The direct method does not reflect any of the interactions among support departments. The step-down method improves upon this by allocating the costs of each support department to other support departments and operating departments, starting with the department that provides the most service (sometimes measured by the total direct costs assuming that larger departments provide more services to other departments). After each department’s cost is allocated, that department drops out of the allocation scheme, so that not all interactions are reflected, but at least some of them are.

H. The reciprocal method improves upon the step-down method by reflecting all of the support department interactions.



8.37 Direct, Step-Down, and Reciprocal Methods, Assigning Costs to Departments – Pelham Town Library

A sample spreadsheet for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. The only cost not already assigned is the building lease cost of $24,000. Either number of employees or square metres can be used as an allocation base. Square metres is a more logical base, reflecting the amount of space each department occupies. For example, the Janitorial department occupies 500/2,500 square metres, so it is allocated 20% of the lease cost. Total costs assigned to each department are computed by adding direct costs to allocated lease costs. Below is an excerpt from the sample spreadsheet for this problem:

Problem 8.37: Pelham Town Library

Direct Costs Janitorial Administration Books Other Media Total Salaries $20,000 $40,000 $50,000 $70,000 $180,000 Supplies 5,000 5,000 15,000 25,000 50,000Other Costs Building lease 24,000Total Costs $254,000

Allocation Base Volumes Square metres 50 50 120 30 250 Number of employees 1 1 2 1 5

Building Lease Allocation:

% square metres 20% 20% 48% 12% 100%Allocation $4,800 $4,800 $11,520 $2,880 $24,000

Total Assigned Costs $29,800 $49,800 $76,520 $97,880 $254,000

B. This problem is very similar to direct method problems illustrated in the chapter. However, students need to identify the departments that provide support services (administration and janitorial) and the operating departments (books and other media). The solution shown below assumes that janitorial services are allocated using square metres and administration is allocated using number of employees. Here is an excerpt from the sample spreadsheet for this problem:


100 Cost Management

DIRECT METHOD ALLOCATION

Janitorial Administration Books Other Media TotalAllocation Bases: Square metres 120 30 150

80.00% 20.00% 100% Number of employees 2 1 3

66.67% 33.33% 100%

Total Assigned Costs $29,800 $49,800 $76,520 $97,880 $254,000Allocations: Janitorial (29,800) 0 23,840 5,960 0 Administration 0 (49,800) 33,200 16,600 0Total Allocated Costs $0 $0 $133,560 $120,440 $254,000

Support Departments Operating Departments

C. Under the step-down method, it is necessary to identify the support department that provides the most services. Because Administration is the largest department when comparing support department costs, it will be allocated first. Below is an excerpt from the sample spreadsheet for this problem.

STEP-DOWN METHOD ALLOCATION

Janitorial Administration Books Other Media TotalAllocation Bases: Square metres 120 30 150

80.00% 20.00% 100% Number of employees 1 2 1 4

25% 50% 25% 100%

Total Assigned Costs $29,800 $49,800 $76,520 $97,880 $254,000Allocations: Administration 12,450 (49,800) 24,900 12,450 0 Janitorial (42,250) 0 33,800 8,450 0Total Allocated Costs $0 $0 $135,220 $118,780 $254,000


D. Under the reciprocal method, the simultaneous equations for the support department allocations are developed first.

Simultaneous equations:

Admin = $49,800 + (50/200 square metres) * JanitorJanitor = $29,800 + (1/4 employees) * Admin



Here are calculations for solving the simultaneous equations manually. First substitute the Janitor equation into the Admin equation and solve for Admin:

Admin = $49,800 + (50/200) * [$29,800 + (1/4) * Admin]Admin = $49,800 + 0.25* $29,800 + 0.25 * 0.25 * AdminAdmin = $49,800 + $7,450 + 0.0625*AdminAdmin = $57,250 + 0.0625*Admin0.9375*Admin = $57,250Admin = $57,250/0.9375Admin = $61,067

Now substitute Admin into the Janitor equation and solve for Janitor:

Janitor = $29,800 + (1/4) x $61,067 = $45,067

Below is an excerpt from the sample spreadsheet for this problem. It shows the results using Excel Solver to solve the simultaneous equations and allocate the support department costs.

Square metres 50 120 30 20025% 60% 15% 100%

Number of employees 1 2 1 425% 50% 25% 100%

Total Assigned Costs $29,800 $49,800 $76,520 $97,880 $254,000Allocations: Administration 15,267 (61,067) 30,533 15,267 0 Janitorial (45,067) 11,267 27,040 6,760 0Total Allocated Costs $0 $0 $134,093 $119,907 $254,000

8.38 Stand-alone and Incremental Cost Allocation Methods - Monty

A. Under the stand-alone method, the Frankfurt outlet would pay €250/(€250+€200)* €300 = €167, and Paris would pay the remaining €133.

B. Under the incremental cost-allocation method the cost to Frankfurt’s outlet would be €250, and the cost to the Paris outlet would be €50 (€300-€250).

C. A criterion is needed to evaluate fairness. In this particular problem, the perception of fairness probably depends on each individual manager’s view. From the perspective of the Frankfurt manager, the difference between the two costs depended only on who called first. If Paris had called at a later time, after the airfare to Frankfurt had already been booked, the cost to Paris would have been the complete round trip fare from London. Thus, the Frankfurt managers would consider the stand-alone method to be


102 Cost Management

fairer than the incremental cost-allocation method. However, the Paris manager would probably argue the other way around.

Another way to split the cost between the two outlets would be for each outlet to pay 50% of the total fare. This may be perceived as the most fair. For this specific problem, the differences in amounts that each outlet pays are small, so fairness may not be an issue. However, when differences are larger, perceptions of fairness become more important.

8.39 Step-Down and Reciprocal Methods, Uncertainties, Pricing - Kovacik


A. Under the step-down method, the direct costs of Information Systems are allocated first because they are larger than the direct costs for the other support department (Engineering). In the first step, Information Systems costs are allocated to all other departments using the percent of services used as given in the problem. In the second step, the percentages for Engineering and Design must be adjusted to remove the percent of services used by Information Systems. Thus, the percent allocated to the Plain Bank department is 40%/(100%-10%), or 44.444%. The percent allocated to the Metallic Bank department is 50%/(100%-10%), or 55.5556%. The total cost allocated in step 2 of $4,300 is equal to the Engineering and Design direct costs of $2,700 plus $1,600 in costs allocated from Information Systems.

Support Departments Operating DepartmentsEngineering Informationand Design Systems Plain Bank Metallic Bank Total

Allocation Bases:Information systems 20% 30% 50% 100%Engineering and design 44.4444% 55.5556% 100%

Direct Costs $2,700 $8,000 $10,000 $20,000 $40,700Allocations:

Step 1: Information systems 1,600 (8,000) 2,400 4,000 0Step 2: Engineering and design (4,300) 0 1,911 2,389 0

Total Allocated Costs $ 0 $ 0 $14,311 $26,389 $40,700

B. Calculation of estimated total allocated cost per unit using costs calculated under the step-down method:

Allocated Cost/Production Volume Allocated Cost Per UnitPlain bank $14,311/8,000 units $1.789Metallic bank $26,389/4,000 units $6.597

C. Actual total allocated costs will be different than budgeted total allocated costs because budgets never exactly predict costs or production levels. Production levels change because of unanticipated changes in product demand, unexpected production stoppages,



delays in receipt of materials, and so on. There are many reasons for actual costs differing from budgeted costs, such as:

* There can be unexpected inflation or deflation in the costs of materials, labour, supplies, etc.

* Employment levels fluctuate because employees leave unexpectedly, it takes longer than expected to hire new employees, or management decides to change the number or types of employees.

* Unanticipated new types of materials, designs, or technologies can be adopted, altering production costs.

* Capacity constraints occur if demand is higher than usual. As organizations near their capacity levels, costs of congestion increase and money may be spent to relax the constraint.

* Changes in product design or the manufacturing process affect the amount and cost of materials and labour.

D. Under the reciprocal method, the simultaneous equations for the two support departments are:

Engineer = $2,700 + 20%* InfoInfo = $8,000 + 10% * Engineer

Substituting Engineer into the Info equation and solving for Info:

Info = $8,000 + 10% * ($2,700 + 20% * Info)Info = $8,000 + 270 + 0.10 * 0.20 * InfoInfo = $8,270 + 0.02 * Info0.98 * Info = $8,270Info = $8,270 / 0.98Info = $8,439

Substituting Info back into the equation for Engineer:

Engineer = $2,700 + 20% * $8,439 = $4,388


104 Cost Management

The cost allocations are performed as follows:

Support Departments Operating DepartmentsEngineering Informationand Design Systems Plain Bank Metallic Bank Total

Services used:Engineering and design 10% 40% 50% 100%Information systems 20% 30% 50% 100%

Direct Costs $2,700 $8,000 $10,000 $20,000 $40,700Allocations:

Engineering and design (4,388) 439 1,755 2,194 0Information systems 1,688 (8,439) 2,532 4,219 0

Total Allocated Costs $ 0 $ 0 $14,287 $26,413 $40,700

E. Calculation of estimated total allocated cost per unit using costs calculated under the reciprocal method:

Allocated Cost/Production Volume Allocated Cost Per UnitPlain bank $14,287/8,000 units $1.786Metallic bank $26,413/4,000 units $6.603



PROBLEMS

8.40 Department Allocations, Decision Making – Haley’s Department Store

[Note: This problem requires application of knowledge from Chapter 4.]

A. Because the firm allocated store maintenance costs to only three departments, the confectionery shop did not receive an allocation. Accordingly, store maintenance costs were allocated as follows:

Allocation rate = $95,000/950 m2 = $100 per m2

Building costs allocated to departments:Clothing (600 m2× $100) $60,000Bedding (150 m2× $100) 15,000Jewellery (200 m2× $100) 20,000

Total allocation $95,000

Earnings after allocation of building costs:Clothing ($72,000 – $60,000) $12,000Bedding ($19,500 – $15,000) 4,500Jewelry (40,000 – $20,000) 20,000Confections (4,000 – $0) 4,000

B. Earnings per m2:

Clothing ($12,000/600 m2) $20 per m2

Bedding ($4,500/150 m2) $30 per m2

Jewellery ($20,000/200 m2) $100 per m2

Confections ($4,000/50 m2) $80 per m2

Jewelry would be expanded, and Clothing would be reduced or dropped.

C. Contribution margin per square metre:

Clothing ($72,000/600 m2) $120 per m2

Bedding ($19,500/150 m2) $130 per m2

Jewellery ($40,000/200 m2) $200 per m2

Confections ($4,000/50 m2) $80 per m2

Jewelry would be expanded and Confections would be reduced or dropped.

D. Allocations of the building costs reflect unavoidable costs that should not be used in decision making. That is, these costs will be incurred no matter what product mix is used in the space. Therefore, the contribution margins per square metre in Part C are the better for decision making.


106 Cost Management

Several qualitative factors may enter into this decision. It is possible that customers such as families come into the store to purchase confections and then buy other products. It is also possible that increasing the square metres for one product will not increase sales because the store has regular customers who purchase a specific mix of these products. Students may think of other qualitative factors.

8.41 Single VersusDual Rates, Manager Incentives, Transfer Pricing – Cheng and Gonzales

A. Total budgeted hours = 300+350+400 = 1,050Total budgeted maintenance costs = $16,000 + ($35 × 1,050 hours) = $52,750Single rate based on budgeted hours = $52,750/1,050 = $50.2381 per hour

Single-rate allocation of maintenance costs using budgeted hours:West Coast (300 × $50.2381) $15,072Midwest (350 × $50.2381) 17,583East Coast (400 × $50.2381) 20,095


B. Total actual hours = 270 + 380 + 400 = 1,050Total allocated maintenance costs = $16,000 + ($35 × 1,050 hours) = $52,750Single rate based on actual hours = $52,750/1,050 = $50.2381 per hour

Single-rate allocation of maintenance costs using actual hours:West Coast (270 × $50.2381) $13,564Midwest (380 × $50.2381) 19,091East Coast (400 × $50.2381) 20,095


C. Fixed cost rate based on budgeted hours = $16,000/1,050 = $15.2381 per hourVariable rate = $35 per hour

Dual-rate allocation using budgeted hours for fixed costs and actual hours for variable costs:

West Coast (300 × $15.2381) + (270 × $35) $14,022Midwest (350 × $15.2381) + (380 × $35) 18,633East Coast (400 × $15.2381 + (400 × $35) 20,095


D. The optimal use of the maintenance department would be to keep the trucks washed, serviced and repaired in a manner to achieve the highest margins from trucking operations, which means achieving the minimum amount of breakdowns with the least cost possible. Each trucking department would use the maintenance resources to minimize downtime and cost.



E. 1. If a single rate method with budgeted hours is used, managers would tend to underestimate the amount of hours that would be used and then use more hours than budgeted.

2. If a single rate method with actual hours is used, managers would tend to focus on controlling maintenance costs.

3. If a dual rate method is used, managers would have an incentive to estimate maintenance hours needed more accurately and to control their use of variable maintenance costs.

F. Cheng and Gonzales may want to set transfer prices so that the maintenance services will be used optimally. They may want to set a price per task and keep prices low on tasks that will reduce costs in the long run, such as oil changes, but increase the price on services that do not affect the life of the trucks, such as a thorough cleaning of the truck cab. Repairs could be charged out at variable cost so that they are always done in a timely manner. Advantages of this system are that managers will use the resources more optimally. A big disadvantage is the time and cost needed to determine the prices and change them over time as costs change.

8.42 Step-Down and Reciprocal Methods, Choosing Methods, Cost Pools, Uncertainties - Physician Brother

A. Both methods are appropriate for allocating support department costs to health program departments. The step-down method ranks support departments in order of service provided and then allocates their costs to other departments according to a cascading method. The support department providing most services is allocated first to all other departments, and is then dropped from the allocation process. Next, the support department providing the second-most services is allocated to the remaining departments, and then it drops out, and so on until all support department costs are allocated. Therefore, this method partially takes into account the fact that the support departments provide services for each other.

The reciprocal method uses simultaneous equations to reflect all of the services provided among the support departments. Therefore, the reciprocal method more accurately measures support department costs before those costs are allocated to the health program departments.

B. Here are some factors that the physician should consider to choose the best allocation method and best allocation bases.

Choosing the allocation method: If you only have a few support activities, the two methods are likely to produce similar allocations. However, the step-down method is easier to calculate and understand, so you may prefer that method. Alternatively, if there are a number of support departments, you will want to use the reciprocal method because it more accurately measures the cost of support services. You can either purchase software for these allocations, or I can set up a spreadsheet and show you how to use it.


108 Cost Management

Choosing an allocation base: An allocation base is some measure of activity that is used to determine the amount of a support department’s cost that is allocated to each of the other departments. Ideally, you would like to choose allocation bases that are also cost drivers, that is, they cause costs to vary. For example, the number of patients would be a good allocation base for the cost of medical records because costs such as supplies and employee time are likely to vary with the number of patients. Square metres might be a good allocation base for the cost of janitorial services because those costs might vary with the square metres of space that is cleaned. If you choose cost drivers for allocation bases, the resulting allocations do a better job of measuring the use of resources. Give some thought to what might cause costs to change when you choose allocation bases for each cost pool.

C. The types of costs in a cost pool depend on the size and structure of the organization and also the manner of service provision. Some organizations may own no vehicles and incur costs only for renting and operating vehicles. Other organizations may have a large motor pool that requires a manager and several employees to maintain the vehicles.

8.43 Cost Pools and Allocation Bases - Defense Contractor

A. Examples include: new product design, design of the manufacturing process, product re-design, and product testing.

B. Possible allocation bases:

• New product design: number of new products, labour hours• Design of manufacturing process: labour hours, number of designs• Product redesign: number of engineering change orders• Product testing: number of hours in testing, number of products tested

C. Factors to consider in choosing cost pools and allocation bases:

• The cost and benefit tradeoffs for collecting information.• Whether cost can be measured accurately for each pool.• Whether the activity uses as an allocation base that can be measured accurately.• Whether the activity uses as an allocation base that reflects the flow of resources

used, at least partially.



8.44 Step-Down Method, Choosing Allocation Order and Bases - Space Products

A. Step-down method allocation:Administrative MIS Commercial Military

Direct costs $ 600,000 $ 200,000 $2,000,000 $4,000,000

Allocation of Administrative Costs:Number of Employees 10 40 50Percent 10% 40% 50%Cost (600,000) 60,000 240,000 300,000

Allocation of MIS Costs:CPUs 30 70Percent 30% 70%Cost $(260,000) 78,000 182,000

Total Allocated Cost $ 0 $ 0 $2,318,000 $4,482,000

Support dept costs allocated to Military:Total allocated cost less direct cost$4,482,000 - $4,000,000 = $482,000

B. Average Cost Per Military Satellite= Total allocated cost ÷ Number of satellites produced= $4,482,000 ÷ 100 = $44,820

C. The average cost is most likely an overstatement of incremental cost. The average cost includes fixed costs, which do not vary with the level of production (in the short run).

D. Direct method allocation; Maximum support costs allocated to military

PWGSC allocation bases for Administrative:Commercial Military

Direct costs $2,000,000 (33%) $4,000,000 (67%)Employees 40 (44%) 50 (56%)

More administrative costs would be allocated to Military if direct costs were used as the allocation base (because 67% is greater than 56%).

PWGSC allocation bases for MIS:Commercial Military

Direct costs $2,000,000 (33%) $4,000,000 (67%)CPUs 30 (30%) 70 (70%)

In this case, CPUs would maximize the cost allocated to the Military division.


110 Cost Management

Allocations: Commercial Military

Administrative (based on direct costs) $200,000 $400,000MIS (based on CPUs) $ 60,000 $ 140,000

Total Allocated Support Costs $260,000 $540,000

E. Policy to Maximize PWGSC Contribution1. The PWGSC does not mandate a single allocation method because different defense

contractors are organized differently and have different types of costs. In addition, there is always discretion because there are uncertainties in defining cost pools, assigning costs to cost pools, and specifying allocation bases. It would be impossible to prescribe a single allocation method that would accurately measure support costs on defense contracts and that would be fair to all contractors.

2. As a taxpayer, I would prefer that the cost be allocated in a manner that fairly represents the amount of overhead used by military projects. I would prefer not to subsidize the overhead costs of a private corporation.

3. As a competitor, I would prefer that the cost be allocated in such a manner that the contractor did not have an unfair competitive advantage. The government should pay its fair share, but no more. I would like to see some benchmark information about the amount of internal support department cost per job for commercial versus government contracts.

8.45 Categorization of Support Costs -- BBB Wise Giving Alliance

A. Uncertainties in cost classification:1. The newsletter costs have no clear classification because the function of the

newsletter seems to be partly fundraising and partly educational. Perhaps the cost should be allocated between fundraising and program. However, it might not be possible to identify an appropriate allocation base to separate these activities. Also, it could be argued that providing recipes is not educational. However, the recipes are most likely designed to save costs and to be nutritious, which would support their classification as educational. In addition, classification as “educational” does not necessarily mean that the newsletter is a program activity. On the one hand, knowledge about the needs of low-income individuals is probably conveyed through the newsletter. Educating the public and promoting greater awareness can be important program goals for a charitable organization. It can also be important for the public to learn about the activities of charitable organizations. On the other hand, the newsletter probably provides little, if any, direct benefit to the target of its charitable mission—low-income individuals who are unable to leave their homes.

2. Classification of the director’s salary and benefits is uncertain because the proportion of cost is unknown that relates to fundraising activities, to administration, or to program activities. Even if detailed information were available about the time the director spends on various activities, there would still be uncertainty about whether to



use time spent to assign her salary and benefits. An alternative might be to identify the proportion of “value” she devotes to various activities. In addition, some of the director’s activities probably relate to more than one cost category. For example, her time at a board of director’s meeting might be considered administrative. However, the board probably discusses program issues such as whether to hire a new cook or to purchase a new delivery vehicle. She might also persuade board members to donate money while at a meeting.

B. This situation involves an ethical dilemma for the bookkeeper, who must decide how to assign costs. It also involves an ethical dilemma for the director, who is responsible for the financial statements. Both of these individuals have a responsibility to the organization, to individuals who receive the organization’s services, and to donors and other parties who rely on its financial statements. This situation involves a possible conflict of interest among interested parties, and requires the bookkeeper and director to apply judgment, along with personal and organizational values, in deciding what to do.

C. The director probably prefers to classify costs as related to the program cost pool. A larger proportion of program costs makes the organization look more efficient in its use of resources, and also gives the appearance of appropriate effort from management.

D. Donors would prefer costs to be assigned in an unbiased way—program costs should include the resources used for program purposes, fundraising costs should include resources used for raising money, and administrative costs should include resources used for general management of the organization. However, as discussed in Part A above, there are many uncertainties about classification. Therefore, it is also not clear how the donors would prefer to see these costs classified.

E. Because of the incentives discussed in C above, costs are likely to be classified in the program cost pool when (1) the classification is uncertain and (2) a reasonable argument can be made for classification as program. This creates a bias in favour of classifying costs as program. Accordingly, program costs on average are likely to be overstated.

F. This is an open-ended problem, so there is no single solution. It is possible to argue for different types of allocations. The best solutions: (1) take into account uncertainties about how the costs should be classified, and (2) are designed to create an unbiased classification of costs (i.e., to avoid misleading donors and others).


112 Cost Management

8.46 Direct, Step-Down, and Reciprocal Methods Using Dual Rate and Three Departments – Melodious Notes

A sample spreadsheet using Solver for the allocations in this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. Following is a diagram of the direct method allocation for Melodious Notes.

Support Departments Operating Departments Units

B. Following is the dual-rate, direct method allocation for Melodious Notes.

Support Departments Operating DepartmentsAdministration Accounting Custodial Services Instruments Lessons Total

Allocation Bases:Variable and fixed administration costs:

Number of employees 5 3 862.5000% 37.5000% 100%

Variable and fixed accounting costs:Timespent accounting (50%/75%) (25%/75%)

67% 33% 100%Variable custodial services costs:

Timespentcleaning (55%/85%) (30%/85%)65% 35% 100%

Fixed custodial services costs:Squaremetres 800 100 900

88.8889% 11.1111% 100%

Cost Allocations:Direct support costs $61,400 $36,840 $60,360 $158,600


Administration

Accounting

Instrument Sales

Cost Pool

Music Lessons Cost Pool

Instruments Sold

Music Lessons Given

Custodial Services


Allocate administration:Variable (11,052) $ 6,908 $ 4,145 0Fixed (50,348) 31,468 18,881 0

Allocate accounting:Variable (9,210) 6,140 3,070 0Fixed (27,630) 18,420 9,210 0

Allocate custodial services:Variable (30,180) 19,528 10,652 0Fixed (30,180) 26,827 3,353 0

Total Support Allocations $ 0 $ 0 $ 0 $109,290 $49,310 $158,600

C. Following is a diagram of the step-down method allocation for Melodious Notes.

Step 1 Allocation:Other Support Departments:

Operating Departments


Administration

Custodial

Instrument Sales

Cost Pool


Accounting

114 Cost Management

Step 2 Allocation:Other Support Department:

Operating Departments:

Step 3 Allocation:

Operating Departments:

D. When performing dual-rate allocations under the step-down method, it is necessary to decide whether to rank supports based on their total services performed, or to rank them separately for fixed and variable support services. Solutions for both approaches are shown below. (Differences in addition are due to rounding.)


Accounting

Instrument Sales

Cost Pool


Instruments Sold

Music Lessons Given

Custodial

Accounting

Instrument Sales

Cost Pool



Approach #1: Rank support departments based on total services (fixed and variable costs)

Under this approach, Administration costs are allocated first because its total direct costs are greater than the other two support departments. Custodial Services is allocated second, and Accounting is allocated third.

Support Departments Operating DepartmentsAdministrationCustodial Services Accounting Instruments Lessons Total

Allocation Bases:Variable and fixed administration costs:

Number of employees 2 1 5 3 1118.1818% 9.0909% 45.4545% 27.2727% 100%

Variable housekeeping costs:Time spent cleaning (5%/90%) (55%/90%) (30%/90%)

5.5556% 61.1111% 33.3333% 100%Fixed housekeeping costs:

Square metres 30 800 100 9303.2258% 86.0215% 10.7527% 100%

Variable and fixed accounting costs:Time spent accounting 50%/75% 25%/75%

66.6667% 33.3333% 100%

Cost Allocations:Direct support costs $61,400 $36,840 $60,360 $158,600Step 1: Administration

Variable (11,052) 2,009 1,005 $ 5,024 $ 3,014 0Fixed (50,348) 9,154 4,577 22,885 13,731 0

Step 2: Custodial ServicesVariable (32,189) 1,788 19,671 10,730 0Fixed (39,334) 1,269 33,836 4,229 0

Step 3: AccountingVariable (12,003) 8,002 4,001 0Fixed (33,476) 22,317 11,159 0

Total Support Allocations $ 0 $ 0 $ 0 $111,736 $46,864 $158,600


116 Cost Management

Approach #2: Rank support departments separately for fixed and variable cost allocations

For variable support costs under this approach, Custodial Services costs are allocated first because its direct variable costs are greater than the other two support departments. Administration is allocated second, and Accounting is allocated third. For fixed support costs, Administration is allocated first, Custodial Services second, and Accounting third.

Support Departments Operating DepartmentsAdministrationCustodial Services Accounting Instruments Lessons Total

Variable Support Allocation Bases:Variable Custodial Services costs:

Time spent cleaning 10% 5% 55% 30% 100%

Variable administration costs:Number of employees 1 5 3 9

11.1111% 55.5556% 33.3333% 100%Variable accounting costs:

Time spent accounting 50%/75% 25%/75%66.6667% 33.3333% 100%

Fixed Support Allocation Bases:Fixed administration costs:

Number of employees 2 1 5 3 1118.1818% 9.0909% 45.4545% 27.2727% 100%

Fixed custodial services costs:Square metres 30 800 100 930

3.2258% 86.0215% 10.7527% 100%Fixed accounting costs:

Time spent accounting 50%/75% 25%/75%66.6667% 33.3333% 100%

Variable Cost Allocations:Variable support costs $11,052 $30,180 $ 9,210 $ 50,442Step 1: Custodial Servises 3,018 (30,180) 1,509 $ 16,599 $ 9,054 0Step 2: Administration (14,070) 1,563 7,817 4,690 0Step 3: Accounting (12,282) 8,188 4,094 0Total Variable 0 0 0 32,604 17,838 50,442

Fixed Cost Allocations:Fixed support costs $50,348 $30,180 $27,630 108,158Step 1: Administration (50,348) 9,154 4,577 22,885 13,731 0Step 2: Custodial Services (39,334) 1,269 33,836 4,229 0Step 3: Accounting (33,476) 22,317 11,159 0Total Fixed 0 0 0 79,038 29,119 108,158

Total Allocations $ 0 $ 0 $ 0 $111,642 $46,958 $158,600



E. The dual-rate method requires two sets of simultaneous equations for the reciprocal allocations.

Variable support cost simultaneous equations (Note: These equations were shown in the textbook on page 340):

Administration = $11,052 + 15%*Accounting + 10%*Custodial ServicesAccounting = $9,210 + (1/11)*Administration + 5%*Custodial ServicesCustodial Services = $30,180 + (2/11)*Administration + 10%*Accounting

Fixed support cost simultaneous equations:

Administration = $50,348 + (600/9,900)* Custodial Services + 15% * AccountingAccounting = $27,630 + (1/11)*Administration + 300/9,900)* Custodial ServicesCustodial Services = $30,180 + (2/11)*Administration + 10%*Accounting

F. Below is an excerpt from the sample spreadsheet for this problem, showing the variable support cost allocation under the reciprocal method. Except for minor rounding differences, these allocations agree with those shown in Exhibit 8.12, textbook page 363.

RECIPROCAL ALLOCATIONS FOR VARIABLE SUPPORT COSTS

Administration Accounting Cust. Serv. Instruments Lessons Total

Allocation Bases:Variable and fixed administration costs: Number of employees 1 2 5 3 11

9.0909% 18.1818% 45.4545% 27.2727% 100%Variable and fixed accounting costs: Time spent accounting 15% 10% 50% 25% 100%

Variable custodial services costs: Time spent cleaning 10% 5% 55% 30% 100%

Solver for Variable CostsAdmin Account Cust

Change cells for Solver $16,354 $12,416 $34,395

Simultaneous equations $16,354 $12,416 $34,395

Target function:$63,166

Administration Accounting Custodial Instruments Lessons Total

Varible Support Costs $11,052 $9,210 $30,180 $50,442Variable Support Allocations: Administration (16,354) 1,487 2,973 $7,434 $4,460 0 Accounting 1,862 (12,416) 1,242 6,208 3,104 0

Custodial Services 3,440 1,720 (34,395) 18,917 10,319 0Total Variable Allocations $0 $0 $0 $32,559 $17,883 $50,442




118 Cost Management

Below is an excerpt from the sample spreadsheet for this problem, showing the fixed support cost allocation under the reciprocal method. Except for minor rounding differences, these allocations agree with those shown in Exhibit 8.12, textbook page 363.

Allocation Bases:Variable and fixed administration costs: Number of employees 1 2 5 3 11

9.0909% 18.1818% 45.4545% 27.2727% 100%Variable and fixed accounting costs: Time spent accounting 15% 10% 50% 25% 100%

Fixed custodial services costs: Square metres 60 30 800 100 990

6.0606% 3.0303% 80.8081% 10.1010% 100%

Solver for Fixed CostsAdmin Account Cust




Administration Accounting Custodial Instruments Lessons Total

Fixed Support Costs $50,348 $27,630 $30,180 $108,158Fixed Support Allocations: Administration (58,164) 5,288 10,575 26,438 15,863 0 Accounting 5,138 (34,256) 3,426 17,128 8,564 0

Custodial Services 2,678 1,339 (44,181) 35,702 4,463 0Total Fixed Allocations ($0) $0 $0 $79,268 $28,890 $108,158


Here is a summary of the reciprocal method variable and fixed support cost allocations to the operating departments:

Operating DepartmentsInstruments Lessons Total

Variable support costs $ 32,559 $17,883 $ 50,442Fixed support costs 79,268 28,890 108,158

Total allocation $111,827 $46,773 $158,600



8.47 Total Cost Under Alternative Allocation Bases, Special Order Price - Danish Hospital

A. The fixed costs should be allocated based on total activity during the period, which in this case is a month. If minutes are used as an allocation base, this means that total minutes per month must first be estimated.

Cancer Birth DefectsMinutes per scan 30 min 10 minTimes number of scans per month 20 scans 40 scansTotal minutes per month 600 minutes 400 minutes

Percent of Combined Minutes 60% 40%

Using total minutes per month as the allocation base, the cost allocations and cost per scan are calculated as follows:

Cancer Birth DefectsLease ($5,000 * 60%; *40%) $3,000 $2,000Operator salary ($3,000 * 60%; * 40%) 1,800 1,200

Total allocated cost $4,800 $3,200

Divided by number of scans 20 scans 40 scans

Allocated cost per scan $240 $ 80Add direct costs per scan 100 50

Total assigned cost per scan $340 $130

Note: Caution should be exercised in interpreting the $340 as “the cost of a cancer scan.” It is the average cost, including allocated fixed costs. This cost does not represent the incremental cost of a cancer scan.

B. Following is a comparison of the percent of costs that would be allocated to each type of scan under each of the allowed allocation bases:

Cancer Birth DefectsNumber of scans 20 (33%) 40 (67%)Minutes 600 (60%) 400 (40%)

The percent of costs allocated to cancer scans would be higher using minutes as an allocation base (60% of allocated costs, compared to only 33% using number of scans). Thus, the maximum reimbursement from the Federal Government would be achieved using minutes as the allocation base. As computed in part A, this means that the maximum reimbursement would be $340 per scan.

C. Since there is ample idle capacity, the total amount of fixed costs would probably not be affected if the hospital receives the contract. The direct costs are primarily for supplies


120 Cost Management

that are consumed with each scan, so these costs are probably variable. The relevant costs for this decision are the costs that Danish would charge under the contract. In this situation, incremental costs consist only of the direct costs. As long as the fee at least covers the direct cost per scan of $50, the hospital is not expected to lose money and more patients will be served.

D. The minimum acceptable fixed fee is the fee that would cover the hospital’s incremental costs, as discussed in Part C. The calculation in Part C assumed that no fixed costs would change based on the provincial contract. However, the hospital managers cannot be certain that fixed costs would be unaffected by the contract. For example, demand for the machine is uncertain. More paying patients might need the machine, leading to a capacity constraint. In that case, the contract would cause the hospital to forego providing services to other patients (an opportunity cost). Even if no capacity constraint occurs, the hospital managers might want the province contract to cover some of its fixed costs. In that case, the managers would need to decide which fixed costs to include in the bid calculations. They cannot be certain which fixed costs to include because the inclusion of more costs would increase the bid price and reduce the likelihood of obtaining the contract.

E. Possible arguments to discuss in favour of using total allocated costs:

• The organization calculates them for other reports, so the information is readily available.

• Because the information is available, the cost of providing reports for the province will be low if the hospital wins the contract.

• By incorporating overhead costs into the bid, the hospital can recover some of those costs.

• This cost measure approximates the complete cost of providing scan services, at the predicted volume levels

• It is not fair to require other hospital services to pay for support that is necessary for the scan services.

Possible arguments against using total allocated costs:

• It is not necessary to cover all costs; support costs such as administration are covered by the hospital’s primary activities

• Part of the hospital’s mission is to serve indigent individuals; it is unfair to use a cost measure that might reduce the availability of services to those in need.

• The hospital might lose the contract if it uses total allocated costs; another hospital could submit a lower cost bid.

• The total allocated cost changes as volumes change. If the number of indigent patients varies widely from period to period, this cost can underestimate or overestimate the hospital’s actual costs by large amounts. Factors such as economic changes and occasional flu epidemics that are worse than usual will affect volumes of indigent patients using services.



F. This is an open-ended problem, so there is no single solution. It is possible to reasonably argue for several different types of cost to be included or excluded. The best solutions to this question provide: (1) a clear recommendation for the cost report, (2) reasonable arguments for the recommendation, (3) evidence of having considered multiple cost measures, (4) evidence of having considered major issues, and (5) support for the hospital’s interests while also considering interests of other stakeholders, such as the province, taxpayers, and service recipients. In addition, the memo should follow proper formatting and conventions. It should be concise, but at the same time provide sufficient information for the reader to evaluate the quality of the recommendation and to draw his or her own conclusions. In this scenario, the memo can use technical accounting jargon because the hypothetical reader is the head of the accounting department. However, if the memo were written to a non-accountant, technical jargon should be avoided.

8.48 Support Cost Allocation, Uncertainties and Fairness - Steve Kurl

A. There are many uncertainties in allocating overhead costs to each game, and these uncertainties affect the allocation of costs and, in turn, the measurement of profits. For example, until the season is over, no one knows how many games will be played. Therefore, it is difficult to use number of games as the allocation base. If more games are played than planned, there will also be extra overhead cost incurred, so uncertainties exist about the dollar amount that needs to be allocated. If the number of total hours played is used, these would change with number of games played. The number of players per game could be used, especially if a lot of overhead expense is tied to providing support for the players (physicians, coaches, etc.) The problem with this measure is that it will change if someone is injured or expelled for a number of games.

In addition, the amount of overhead costs that should be allocated against the profits of each game is uncertain. At one extreme, it is possible to argue that administrative costs are not expenses at all for individual games because those costs are fixed and must be incurred to run the organization. When Steve signed his contract, he might not have considered the possibility that any administrative expenses would be allocated to each game. The owners, not surprisingly, would argue the opposite extreme—that all administrative costs occur because of the games and should be totally allocated.

B. This is an ethical issue for the owners, managers, and accountants of the team. From Steve’s perspective, the team is unfairly allocating overhead expense. Even if the parties agree that overhead should be allocated to each game, the method being used is likely to allocate more costs than the team incurs when there are post-season games. If the allocated overhead is larger than actual overhead and no adjustments are made when profits are measured for player bonuses, Steve’s bonus is smaller than it should be. The owners, managers, and accountants of the team might not view this as unfair to Steve because they might believe that team players are highly compensated through their regular contracts. However, they have an ethical responsibility for fairness in the way they report profits for each game.


122 Cost Management

C. If the budget is based on the number of regular season games, then the allocation might be unbiased if the team fails to play post-season games. However, when the team plays championship games the total amount of allocated overhead is likely to exceed total actual overhead. This bias occurs because many of the overhead costs are likely to be fixed and do not increase proportionately with post-season play. On the other hand, player strikes can cause fewer games to be played. This could cause total allocated overhead to be less than actual costs.

D. Some amount of administration work and public relations work needs to be performed for each game. Presumably, these services contribute to both the team’s win-loss record and to ticket sales revenue and, thus, affect the profits of each game. In addition, some portion of these costs is likely to be variable. Additional costs are probably incurred during post-season play.

E. Many of the administration and public relations costs are likely to be fixed costs and should not change with number of games. Therefore, any allocation based on number of games is arbitrary and inaccurate. Also, there are questions about what it means to measure the profit of each game. Perhaps overhead costs do not belong in a measure of game profitability.

F. This is an open-ended problem, so there is no single solution. If students decide that it is fair to allocate both fixed and variable administration and public relations costs against individual game profits, then one possibility would be to adjust the allocations at the end of the season based on the actual number of games. Another possibility is to separately allocate fixed and variable overhead costs. Fixed costs could be allocated only against regular season games, and the incremental costs would be individually subtracted from the profit of each game (regular and post-season). Still another possibility is to avoid allocations to individual games and to base bonuses on the overall profitability for the season. Any logical and unbiased allocation method would be appropriate. If students decide that it is not fair to allocate fixed costs, then they might recommend a system that measures profits for each game based on revenues minus variable costs.

8.49 Allowable Costs Under a Cost-Based Contract, Accountant Ethical Responsibility

A. Although cost-based contracts usually provide guidance about which costs to include and which allocation methods are acceptable, there is room for judgment about many different types of costs and about the method that would most fairly allocate costs. The guidance usually provides large categories of costs that are acceptable or not acceptable, but does not address each individual cost. Therefore, a number of costs are likely to require judgment as they are categorized for cost reports.

B. Maximizing reimbursements under cost-based contracts is an ethical issue for accountants because of conflicting interests. Managers, shareholders, and regular customers most likely prefer more costs to be assigned to cost-based contracts. This preference conflicts with the interests of cost-based contract customers and, for governmental contracts, with the interests of governmental agencies, competitors,



taxpayers, and other potential recipients of governmental funds. The accountants who perform the accounting for cost-based contracts must consider these conflicting interests when using judgment to assign costs.

C. Most people would agree that a large overstatement of costs under a cost-based contract is unethical, unless the overstatement is clearly accidental. However, there is likely to be no consensus about smaller overstatements. One perspective is that materiality is irrelevant. An ethical issue concerns the welfare of various stakeholders. Even if the amount seems immaterial, to be fair to everyone, the allocation process should consider the viewpoints of all parties affected by the allocations, no matter how large or small the amounts are. In addition, it can be argued that there is no such thing as a “small” ethical violation. From this perspective, it is not the size of the overstatement that matters, but rather the intent behind the overstatement. Any intentional misstatement would be considered unethical. Another perspective is that misallocations of costs will always occur when judgment is involved. As long as the misallocations are small, then it can be argued that no ethical issue was involved—i.e., that the organization did not attempt to maximize reimbursements under its cost-based contracts.

D. The major stakeholder groups were identified in Part B above. Below are brief comments about the preferences of each group.

Managers and shareholders: It is simple to say that managers and shareholders prefer receiving greater payments under cost-based contracts and, thus, have incentives to overstate contract costs. However, overstatement of contract costs can also have adverse reputation effects and reduce an organization’s ability to obtain future contracts. Contract customers are also likely to increase their monitoring of contract costs, increasing the organization’s compliance costs.

Cost-based contract customers: Clearly, these customers prefer for contract costs to be accounted for properly. However, they must be aware that it is impossible to unambiguously define all allowable and unallowable costs. Therefore, they expect the use of judgment, which can lead to disagreements about allowable costs. In addition, these contracts typically include provisions allowing the customer or an independent party (such as a CA) to periodically audit compliance with contract provisions.

Regular customers: Regular customers are not directly affected by these issues. However, companies that obtain greater reimbursement of overhead costs under cost-based contracts may be able to charge lower prices to regular customers.

For cost-based governmental contracts:

Governmental agencies: Governmental agencies are responsible for monitoring compliance with cost-based governmental contracts. Their preferences are similar to those of the cost-based contract customers discussed above. In addition, governmental agencies are charged with a fiduciary responsibility for spending public funds appropriately. This additional responsibility increases their incentives to monitor contract compliance.


124 Cost Management

Competitors: If a cost-based customer pays more than its fair share of a company’s overhead, the company could be more competitive in pricing other business. Competitors would prefer to have a level playing field.

Taxpayers: Taxpayers want to ensure that their funds are being used appropriately. Thus, their preferences are similar to those of cost-based contract customers. However, most taxpayers are not knowledgeable about accounting and might fail to recognize legitimate accounting uncertainties.

Other potential recipients of governmental funds: Other potential recipients want a level playing field, in which their opportunity to obtain funds is not diminished because of excessive spending on other organizations’ contracts. Overcharging by other organizations reduces the quantity of available funds. It also has indirect effects, such as a reduced willingness of taxpayers and governmental agencies to fund cost-based projects and an increase in compliance and monitoring costs.

E. The trade-offs made by accountants in deciding whether to help their organizations maximize reimbursements under cost-based contracts include all of the issues discussed in the preceding questions—they must evaluate the implications to their own organization as well as to other stakeholders. In addition, they must consider their own ethical values as they establish criteria for recording costs. To clarify their values, they might consider asking questions such as the following. Is it acceptable to recognize all costs under a cost-based contract except those that are explicitly disallowed? Should an attempt be made to classify costs from the perspective of the customer or other stakeholders? Does materiality matter? What are the short-term and long-term implications of assigning a particular cost to the contract?

F. There is no one answer to this part. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).



MINI-CASES

8.50 Step-Down Method, Multiple- Versus Single-Pool Allocations, Manager Incentives - The Gleason Company

A. Building and grounds costs are most often allocated based on square metres. None of the other potential allocation bases relate to the services provided by building and grounds.

The proportion of square feet used by each department is as follows:

Building &Grounds Administration Cafeteria Machining Assembly Total

Square metres 50 100 350 500 1,000Percent 5% 10% 35% 50% 100%

Direct Costs $41,010 $78,270 $4,920 $104,100 $146,700 $375,000Allocation:Building & grounds (41,010 ) 2,051 4,101 14,353 20,505 0

Total Assigned Costs 0 $80,321 $9,021 $118,453 $167,205 $375,000

B. Administration provides services to other departments, making it a support department. Cafeteria provides meals for the employees, so it is a support department. Products are machined and assembled in Machining and Assembly. Because these products are then sold, these departments are considered operating departments.

C. The support departments consist of Factory Administration and the Cafeteria, so this question requires selection and justification of an allocation base for the costs of each of these departments. This is an open-ended question; there is no single answer. The best solutions would evaluate the likelihood that a given allocation base would adequately differentiate between the service resources used by the other departments. This means that reasonable judgment needs to be applied in evaluating how well the various allocation base options would correlate with the use of service resources. Following are examples of reasonable arguments for each of the support departments:

Allocation Base for Factory Administration: The services of Factory Administration relate to running the factory operations. Square metres might be a reasonable choice if administrative services are driven by the physical space a department occupies. However, this is unlikely. The number of purchase orders might be a reasonable choice if administrative services are driven by responsibility for departmental costs, which may be related to the effort involved in purchasing and paying for supplies. Using this same line of reasoning, the dollar amount of direct or assigned costs in each department might be appropriate as an allocation base. Direct labour hours, total labour hours, or number of employees are reasonable choices if administrative services tend to be driven by the management of employees. For Gleason, insufficient information is available about the types of activities that are most closely related to administration services. However, the


126 Cost Management

management of employees is often the primary administrative service in a factory, and number of employees is likely to be representative of this effort. Therefore, the solution in Part D uses number of employees as the allocation base.

Allocation Base for Cafeteria: The services of the Cafeteria relate to providing meals for employees. Because of this, a measure of employees (number or hours) would be the best choice. Because each employee would probably eat one or two meals a day, regardless of hours worked, hours may not reflect the use of meals as well as number of employees. In the following computations, the number of employees is used as the allocation base.

D. In this part, students are NOT asked to calculate total allocated costs. Instead, they are asked to calculate the amount of overhead costs allocated to each operating department using the step-down method and then to compute an overhead rate per direct labour hour. For this reason, the calculations shown below do not include the operating department direct costs.

Although the number of employees is used to allocate the costs for both support departments, the percentages are different because (1) the total volume of the allocation base does not include the volume of the support department being allocated, and (2) under the step-down method the total volume of the allocation base used in the second step excludes the volume of the support department that was allocated in the first step.

Support Departments Operating DepartmentsAdministration Cafeteria Machining Assembly Total

Number of employees:For administration allocation 2 4 5 11

18.1818% 36.3636% 45.4546% 100%For cafeteria allocation 4 5 9

44.4444% 55.5556% 100%

Support Costs (Part A) $ 80,321 $ 9,021 $89,342Allocations:

Step 1: Administration (80,321) 14,604 $29,208 $36,509 0Step 2: Cafeteria (23,625) 10,500 13,125 0

Allocated Overhead Costs $ 0 $ 0 $39,708 $49,634 $89,342

Divide by direct labour hours 3,000 6,000

Overhead rate per hour $13.236 $8.272

E. Calculate the plant-wide overhead rate by dividing total overhead costs by total direct labour hours as follows:

Total overhead costs (Part D) / Total operating department direct labour hours= $89,342 / (3,000+6,000)= $9.927



F. When the step-down method is used, half of the support department interactions are reflected. Because assembly uses more direct labour hours than machining, it receives more overhead cost when direct labour hours are used in a plant-wide, single cost pool. Therefore, it receives more cost than if the services of departments are allocated based on use of the services. The opposite is true for the machining department; it receives less cost under a plant-wide allocation rate than when support costs are allocated based on services used. The step-down method more accurately reflects the use of resources.

G. An advantage of this method is that it is easy to calculate and understand. A disadvantage is that the cost per labour hour is likely to be high because it includes fixed costs that do not change with the number of employees or hours worked. High charges could lead other departments to consider reducing the number of employees in the department by outsourcing some service or product when it may not be cost effective to outsource. Another disadvantage is that the allocation does not attempt to match the flow of resources to products, so some products will appear to be subsidizing other products because overhead resources used by all products is aggregated into only one pool.

H. The machining department manager would consider the cost of outsourcing versus the cost of using direct labour. Quality could also be a factor. In addition, the manager would want to know how department performance would appear to change as a result of outsourcing. If the manager receives a bonus based on the department’s performance (including allocated costs) and is able to offload part of the overhead allocation by reducing use of labour hours, then he/she would have a greater incentive to outsource.

I. The director of finance would be unhappy with the decision to outsource. The overhead that is not allocated to machining is spread among other departments, so the overhead allocations to other departments increase. Because the machining manager’s decision increases incremental costs and does not reduce any of the overhead costs, it increases total cost and is suboptimal for the company as a whole.


128 Cost Management

8.51 Comprehensive Problem, Dual Versus Single Rates, Purpose of Allocation - Vines Company

A sample spreadsheet showing the calculations for this problem under the direct, step-down, and reciprocal methods is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. Below are excerpts from the sample spreadsheet for this problem, which show the direct, step-down, and reciprocal method allocations of fixed support costs. The reciprocal method allocations were performed using Excel Solver.1. Direct method

DIRECT METHOD ALLOCATION--FIXED SUPPORT COSTS

AccountingHuman

Resources Janitorial Women's Men's TotalAllocation bases for direct method fixed support cost allocation: Direct costs $800,000 $500,000 $1,300,000 % for allocation 62% 38% 100% Employees 10 6 16 % for allocation 62.50% 37.50% 100% Square metres 500 500 1,000 % for allocation 50.0000% 50.0000% 100%

Fixed support costs $55,260 $100,696 $60,360 $216,316Allocations: Accounting (55,260) 34,006 21,254 0 Human resources (100,696) 62,935 37,761 0 Janitorial (60,360) 30,180 30,180 0Total allocations $0 $0 $0 $127,121 $89,195 $216,316


2. Step down method

STEP-DOWN METHOD ALLOCATION--FIXED SUPPORT COSTS

AccountingHuman

Resources Janitorial Women's Men's TotalAllocation bases for step-down method fixed support cost allocation: Step 1: Employees 2 4 10 6 22 % for allocation 9.0909% 18.1818% 45.4545% 27.2727% 100% Step 2: Square metres 80 500 500 1,080 % for allocation 7.4074% 46.2963% 46.2963% 100% Step 3: Direct costs $800,000 $500,000 $1,300,000 % for allocation 61.5385% 38.4615% 100%

Fixed support costs $55,260 $100,696 $60,360 $216,316Allocations: Step 1: Human resources 9,154 -100,696 18,308 45,771 27,463 0 Step 2: Janitorial 5,827 0 -78,668 36,421 36,421 0 Step 3: Accounting -70,241 0 0 43,226 27,016 0Total allocations $0 $0 $0 $125,417 $90,899 $216,316




3. Reciprocal method

RECIPROCAL METHOD ALLOCATION--FIXED SUPPORT COSTS

AccountingHuman

Resources Janitorial Women's Men's TotalAllocation bases for reciprocal method fixed support cost allocation: Direct costs $122,800 $120,720 $800,000 $500,000 $1,543,520 % for allocation 7.9558% 7.8211% 51.8296% 32.3935% 100% Employees 2 4 10 6 22 % for allocation 9.0909% 18.1818% 45.4545% 27.2727% 100% Square metres 80 100 500 500 1,180 % for allocation 6.7797% 8.4746% 42.3729% 42.3729% 100%

Solver for Variable Costs:AccountF HRF JanitorF




Fixed support costs $55,260 $100,696 $60,360 $216,316Allocations: Accounting (71,471) 5,686 5,590 37,043 23,152 0 Human resources 10,338 (113,723) 20,677 51,692 31,015 0 Janitorial 5,873 7,341 (86,627) 36,706 36,706 0Total allocations ($0) ($0) $0 $125,442 $90,874 $216,316


B. Below are excerpts from the sample spreadsheet for this problem, which show the direct, step-down, and reciprocal method allocations of variable support costs. The reciprocal method allocations were performed using Excel Solver.

1. Direct method

DIRECT METHOD ALLOCATION--VARIABLE SUPPORT COSTS

AccountingHuman

Resources Janitorial Women's Men's TotalAllocation bases for direct method variable support cost allocation: Time spent accounting 30% 25% 55% % for allocation 55% 45% 100% Employees 10 6 16 % for allocation 62.50% 37.50% 100% Time spent cleaning 30% 40% 70% % for allocation 42.8571% 57.1429% 100%

Variable support costs $18,420 $22,104 $60,360 $100,884Allocations: Accounting (18,420) 10,047 8,373 0 Human resources (22,104) 13,815 8,289 0 Janitorial (60,360) 25,869 34,491 0Total allocations $0 $0 $0 $49,731 $51,153 $100,884



130 Cost Management

2. Step-down method

STEP-DOWN METHOD ALLOCATION--VARIABLE SUPPORT COSTS

AccountingHuman

Resources Janitorial Women's Men's TotalAllocation bases for step-down method variable support cost allocation: Step 1: Time spent cleaning 5% 10% 30% 40% 85% % for allocation 5.8824% 11.7647% 35.2941% 47.0588% 100% Step 2: Employees 2 10 6 18 % for allocation 11.1111% 55.5556% 33.3333% 100% Step 3: Time spent accounting 30% 25% 55% % for allocation 54.5455% 45.4545% 100%

Variable support costs $18,420 $22,104 $60,360 $100,884Allocations: Step 1: Janitorial 3,551 7,101 (60,360) 21,304 28,405 0 Step 2: Human resources 3,245 (29,205) 0 16,225 9,735 0 Step 3: Accounting (25,216) 0 0 13,754 11,462 0Total allocations $0 $0 $0 $51,283 $49,601 $100,884


3. Reciprocal method

RECIPROCAL METHOD ALLOCATION--VARIABLE SUPPORT COSTS

AccountingHuman

Resources Janitorial Women's Men's TotalAllocation bases for reciprocal method variable support cost allocation: Time spent accounting 10% 20% 30% 25% 85% % for allocation 11.7647% 23.5294% 35.2941% 29.4118% 100% Employees 2 4 10 6 22 % for allocation 9.0909% 18.1818% 45.4545% 27.2727% 100% Time spent cleaning 5% 10% 30% 40% 85% % for allocation 5.8824% 11.7647% 35.2941% 47.0588% 100%

Solver for Variable Costs:AccountV HRV JanitorV




Variable support costs $18,420 $22,104 $60,360 $100,884Allocations: Accounting (25,748) 3,029 6,058 9,087 7,573 0 Human resources 3,061 (33,667) 6,121 15,303 9,182 0 Janitorial 4,267 8,534 (72,540) 25,602 34,136 0Total allocations $0 $0 $0 $49,993 $50,891 $100,884


C. For accounting I would use time spent because it probably reflects the use of accounting employees and their salaries would be a large part of the fixed costs. Number of employees is already used for both fixed and variable costs, so I would continue to use it. Time spent in janitorial services probably provides a more accurate reflection of the resources used by each department for janitorial staff, and it’s likely as they spend more time in an area they also use more supplies.

D. Managers may want to use this information for benchmarks to compare current performance to past performance. It’s possible that they use these calculations to develop a transfer price policy for the use of support services.



E. If Vines is using this information for transfer prices, the variable portion is probably a better reflection of the marginal costs to the company of providing support services. These categories also give more precise information for benchmarks. It would be easier to investigate variances if cost pools are smaller and reflect only fixed or variable costs.

8.52 Integration of Information and Information Technology


A.1 and 2. Business decisions addressed in Chapter 8 and relevant information that might

be stored in an electronic database:

Decisions in Chapter 8Examples of ElectronicDatabase Information

Business Decisions:Insourcing or outsourcing

Data used to estimate future relevant costs: Historical costs

Product pricing Data used to estimate future prices, costs and profits: Historical average product cost per unit, historical overhead costs

Improve cost control and efficiency Data used to evaluate trends: Historical and budgeted costs, volumes, and profits

Accounting Method Decisions:Identifying appropriate cost pools for support and operating departments

Departments currently used for budgeting and accounting

Whether to establish separate pools for fixed and variable costs

Evaluate the behavior of costs: Historical costs and volumes of cost drivers

How to assign costs to cost pools (this includes classification of overhead costs under governmental cost-based contracts)

Electronically-stored policy manuals and contractual terms; Classifications used for similar items in the past based on historical accounting and cost report records

Identifying the most appropriate allocation bases for each cost pool

Data currently available, such as historical production volumes, employee time records, direct costs, etc.

Identifying the most appropriate allocation method

Information for making this decision would not likely be stored electronically

Whether the benefits exceed the costs of establishing a more detailed support cost allocation system


Under the step-down method, identifying the best measure for ranking the amount of service provided by support departments

Historical data that could be used for ranking, such as direct costs

Whether to allocate support costs based on estimated versus actual costs and rates.



132 Cost Management

B.1. A sample spreadsheet for this problem is available on the Instructor’s web site for the

textbook (available at www.wiley.com/canada/eldenburg). The documentation in the sample spreadsheet assumes that the data in the spreadsheet is not directly linked to the sources of the data. Therefore, the spreadsheet includes comments describing the sources of information. The sample spreadsheet does not include any other explanations for the reciprocal allocations because it is assumed that the spreadsheet will be used only by people who are familiar with the reciprocal method and how it is performed.

2. This answer will vary from student to student. The purpose is to engage students in a discussion of what it means to document work performed and also to gain an appreciation of the need to design spreadsheets that can be easily understood by other people.

3. This answer will vary from student to student. The purpose is to encourage students to implement recommendations.

C. This answer will vary from student to student. The purpose is to help students reflect on their approaches to technology adoption.

8.53 Integrating Across the Curriculum: Not-for-Profit Accounting – Allocating common costs to programs

A. This answer will vary from student to student. Additional guidance for locating information on the web about not-for-profit restricted funds is available on the textbook web site (www.wiley.com/canada/eldenburg). The description of restricted funds for not-for-profit organizations as provided by the CICA is given below:

4410.02.(c) Restrictions are stipulations imposed that specify how resources must be used. External restrictions are imposed from outside the organization, usually by the contributor of the resources. Internal restrictions are imposed in a formal manner by the organization itself, usually by resolution of the board of directors. Restrictions on contributions may only be externally imposed. Net assets or fund balances may be internally or externally restricted. Internally restricted net assets or fund balances are often referred to as reserves or appropriations.1

RESTRICTED FUND METHOD4410.57 The restricted fund method is a specialized use of fund accounting. …. When an organization follows the restricted fund method, it presents a single general fund, or the total of all general funds, and one or more restricted funds. The purpose of a restricted fund is to record the receipt and use of resources that are subject to restrictions. An organization following the restricted fund method would also present a separate endowment fund if it receives endowment

1CICA Accounting Handbook, section 4410.02(c) (not-for-profit organizations)© 2012 John Wiley and Sons Canada, Ltd.


contributions. All revenue reported in a restricted fund is externally restricted. Resources transferred to a restricted or endowment fund as a result of the organization imposing internal restrictions would be recognized as interfund transfers in accordance with the general Recommendations on fund accounting presented in FINANCIAL STATEMENT PRESENTATION BY NOT-FOR PROFIT ORGANIZATIONS, paragraphs 4400.06 to .17.2

B. Restricted funds allow not-for-profit organizations to measure the cost of separate support and other services and to assign their cost to other departments or uses that use the support resources. This is similar to the uses of support cost allocations in a business organization as the costs are accumulated in a separate fund and then allocated to the general fund and accounted for as needed or as the restrictions apply.

C. Many internal services are accounted for in the general fund of a not-for-profit organization, which is similar to an overall administration cost pool in a business organization. If internal services are used by non-administration not-for-profit activities, then the pooling of internal services with general administration overstates the cost of general not-for-profit management. Essentially, 100% of the internal service costs are assigned to general management, which understates the cost of other activities which should have received a portion of the internal service costs. The result is that general not-for-profit costs appear to be higher than they actually are, making the general not-for-profit appear to be less efficient. At the same time, the costs of other services appear to be lower than they actually are, making those services appear to be more efficient.

D. There is no single answer to this question. The benefits must be weighed against the costs in reaching a conclusion to this question. Restricted funds require the not-for-profit to be more accountable and transparent to the donors providing detail as to how the funds were utilized. While restricted fund accounting might improve cost measurement and accountability, several costs and limitations must also be considered. For example, if the general not-for-profit organization uses most of an internal service, then there may be no benefit from establishing a separate fund. Legal issues should also be considered. When funds are restricted they are not available for general operations and this may leave the general fund short for the current operating period.

2CICA Accounting Handbook, section 4410.57 (not-for-profit organizations)© 2012 John Wiley and Sons Canada, Ltd.

chapter 8 measuring and assigning support department...

Documents