Chapter 4: Measuring and Assigning Support Department Costs

Introduction

From the time of the Industrial Revolution until the early 20th century, manufacturing operations were mainly labor intensive and direct costs comprised the majority of product costs. Since then, indirect costs in the form of automation have gradually replaced labor costs, and for many products are now the major component(s) of total product costs. This increased use of indirect costs in manufacturing has increased the need for costing systems to deal adequately with indirect costs. Factory overhead allocation is so important to obtain accurate cost information, especially in an automated manufacturing environment. The departmental cost allocation approach has three stages: (1) trace all direct manufacturing costs and allocate manufacturing overhead costs to both the support departments and the production departments, (2) allocate the support department costs to the production departments, and finally (3) allocate the production department costs to the products. The most complicated stage in this cost allocation process is the second stage because support departments may provide services for other support departments as well as for production departments. For example, a personnel department provides services for other support departments such as the power generating plant, maintenance department, and stores. The power generating department also provides heat and light for other support departments, including the personnel department and so on. When such interactions occur, the allocation process can become complicated. Difficulties arise because each support department begins to accumulate charges from other support departments from which it receives services, and these must be reallocated back to the user department. Once it has begun, this allocation and reallocation process can continue for a long time before a solution is found. Three different methods are used to solve this complex process. The direct method, stepdown method and reciprocal (algebraic) method can be used to allocate support departments’ costs to production departments. The objective of this chapter is to provide explanation for measuring and assigning support department costs. Based on this aim, cost allocation, support department cost allocation and allocating costs of multiple support departments are emphasized.

Cost Allocation

Cost allocation is the process of assigning costs in a cost pool to the appropriate cost objects with the help of representatives.

Allocation base is the representative that is used as a basis for systematically assigning the joint costs to cost objects. For example, an organization might assign the cost of a truck to periods based on kilometers driven during the period; the allocation base is kilometers.

Operating costs are assigned directly and indirectly to cost objects. Indirect costs assigned in production are monitored under overheads costs. However, since indirect costs cannot be directly assigned to products, they are assigned in three basic stages. If a cost is directly assigned to the cost objects, the term direct cost tracing is used. If a cost is distributed indirectly to the cost object, the term cost allocation is used. Cost allocation is a process of assigning costs to individual products or time periods. Contrast with cost tracing, cost allocations involve the use of a representative rather than direct measures. For example, consider an activity such as receiving incoming materials. Assuming that the cost of receiving materials is strongly influenced by the number of receipts, then costs can be allocated to products (i.e. the cost object) based on the number of material receipts each product requires. The basis that is used to allocate costs to cost objects (i.e. the number of material receipts in our example) is called an allocation base or cost driver. If 20 percent of the total number of receipts for a period were required for a particular product, then 20 percent of the total costs of receiving incoming materials would be allocated to that product. Assuming that the product was discontinued, and not replaced, we would expect action to be taken to reduce the resources required for receiving materials by 20 percent (Drury, 2012: 45).

The Strategic Role of Cost Allocation

The strategic role of cost allocation is linked to four objectives (Blocher, Stout, and Cokins, 2010: 232):

1. Determine accurate departmental and product costs as a basis for the evaluation of the cost efficiency of departments and the profitability of different products, for financial reporting, and for tax compliance.
2. Motivate executives for a high level of effort to achieve the goals targeted by senior management.
3. Right incentives are provided to the managers in order to make a decision consistent with the objectives of the senior management.
4. Identify the fairly rewards that managers earn for their effectiveness in their decisions.

The first and most important objective requires the cost allocation method to be sufficiently accurate to support effective management decision making about products and departments. The management accountant recognizes that the desired cost allocation method might differ for the three objectives: cost management, financial reporting, and tax compliance. The second objective motivating managers mean that in order to be effective, cost allocation should reward department managers as desired to reduce costs. The main issue here is whether the administrator controls the assigned cost. For example, if the cost allocation for a section’s equipment maintenance is based on the number of machine failures of the department, the administrator has the possibility to reduce them and thus reduce their maintenance costs because this is a controllable condition for the administrator. On the other hand, when the maintenance cost is allocated based on the square meters of a section, the manager who does not influence the amount of floor space will not be motivated. The third objective that provides incentives for decision-making is achieved when the cost allocation effectively empowers authorized individual managers to act autonomously with the goals of the senior management. One of the biggest advantages of cost allocation methods is to attract managers’ attention to common facilities. The cost allocation provides an incentive for individual efforts to encourage managers to plan, manage, and improve the performance of these facilities. The fourth objective, impartiality, is met when cost allocation is implemented in an explicit and objective manner. The most objective approach for cost allocation occurs when the cause-effect relationship can be established. For example, based on the number of failures of machinery, the allocation of maintenance costs is more objective and fair than an allocation based on the number of square meters, the number of products produced, or the labor costs in the department. This situation should be evaluated in terms of a cause-effect relationship. While there is a logical relationship between maintenance costs and the number of failures, there is no clear relationship between labor costs and maintenance costs (Blocher, Stout, and Cokins, 2010: 232-233).

Objectives of Cost Allocation

Indirect costs are not directly identified with a cost object. Indirect costs of a particular cost object are costs that are related to that cost object but cannot be traced to it in an economically feasible or cost-effective way. Indirect costs often comprise a sizable percentage of the costs assigned to cost objects such as products, distribution channels, and customers. The four objectives for allocating indirect costs to these cost objects are as follows (Bhimani, Horngren, Datar and Rajan, 2015: 124):

1. To provide information for economic decisions,
2. To motivate managers and employees,
3. To justify costs or calculate reimbursement,
4. To measure income and assets for reporting to external parties.

The allocation of a specific cost may not at the same time fulfill all the objectives we have mentioned above. Consider the salary of a scientist in a central research department. This salary cost may be allocated as part of central research costs to satisfy purpose 1 (economic decisions); it may or may not be allocated to satisfy purpose 2 (motivation); it may or may not be allocated to a government contract to justify a cost to be reimbursed to satisfy purpose 3 (cost reimbursement); and it must not be allocated (under generally accepted accounting principles) to stock to satisfy purpose 4 (income and asset measurement) (Bhimani, Horngren, Datar and Rajan, 2015: 124).

Types of Departments

In organizations, departments are classified under two headings: operating departments and support departments. An operating department performs the actual manufacturing operations that physically change the units being processed. Because the operating departments receive the benefit of the work performed by the support departments, the total cost of production must include not only the costs incurred directly in the operating departments but also a portion of the costs of operating the service departments. Therefore, the total product costs should include a share of support department costs. A support department is an essential part of the organization, but it does not work directly on the product. The product indirectly receives the benefit of the work performed by the support department. Examples of support departments include a department that generates power for the factory and a building maintenance department that is responsible for maintaining the buildings.

Organizations are usually classified under two headings: operating departments and support departments. An operating department (also called a production department in manufacturing companies) adds value to a product or service that is observable by a customer. These departments are directly responsible for creating the products or services sold to customers. In a large accounting firm, examples of operating departments are auditing, tax, and management advisory services. In a manufacturing setting such as an automobile manufacturer, production departments are those that work directly on the products being manufactured (e.g., assembly and painting). A support department (also called a service department) provides the services that maintain other internal departments (operating departments and other support departments) in the organization. These departments provide basic and supportive services for operating departments. These departments are therefore indirectly linked to the services or products of the enterprise. At an automobile manufacturer company, those departments might include engineering, maintenance, and personnel (Guan, Hansen and Mowen, 2006: 210). Exhibit 4.1, on page 83, shows how a manufacturing company and a service company can be divided into production and support departments. Based on a business that manufactures furniture as a production enterprise. Assume that there are two production departments in this enterprise, including assembly and finishing, and four support departments, including materials storeroom, cafeteria, maintenance, and general factory. Let us take the bank as a service business. Assume that there are three operating departments, auto loans, commercial lending, and personal banking, as well as three support departments such as drive-through, data processing and bank administration. Overhead costs are traced to each department.

Departmental Cost Allocation

There are three stages in the allocation of indirect costs. The first stage; direct costs are traced directly and indirect costs are allocated to operating and support departments. In addition, if they have period expenses they are also transferred to the income statement. The second stage; allocate service department costs to operating departments. The third stage; allocate operating department costs to products.

The departmental cost allocation approach has three stages: (1) trace all direct manufacturing costs and allocate manufacturing overhead costs to both the support departments and the operating departments, (2) allocate the support department costs to the operating departments, and finally (3) allocate the operating department costs to the products (Blocher, Stout, and Cokins, 2010: 234).

Support Department Cost Allocation

A support department is a unit not directly involved in producing the goods or services of the organization but supporting the operating departments. An organization must have a support department, such as the Maintenance Department or the Human Resources Department, to perform its primary function. Therefore, the cost of running a support department is a part of the cost of the organization’s production of goods or services. In order to accurately determine the cost of such goods or services, the entire support department should allocate its costs to the operating departments in which the goods or services are produced. Therefore, costs incurred in the support departments of an automobile factory, such as the Maintenance Department, are allocated to the operating departments according to the services they provide (Hilton, 2008: 752). As a result, the accuracy of the cost allocations of the support department will result in an accurate calculation of the product, service and customer costs.

Allocating One Department’s Costs to Another Department

In order to allocate the cost of the support department, an activity volume is determined first and then the charging rate based on this volume of activity is calculated. With this charging rate, allocation to other departments is also made. For example, a company’s data processing department may serve various other departments. The cost of the data processing department is then allocated to the user departments that it serves. While this deployment may seem simple and understandable, there are a number of important things to be able to determine an appropriate charging rate (Guan, Hansen and Mowen, 2006: 213). There are two important issues in calculating the charging rate:

1. The choice of a single or a dual charging rate and
2. The use of budgeted versus actual support department costs.

Single-Rate and Dual-Rate Methods

The single-rate method does not discriminate between fixed and variable costs. It allocates costs in each cost pool to cost objects using a single charging rate. In contrast, the dual-rate method divides the cost of each support department into two separate pools, variable and fixed. It distributes the cost of each pool by using a different charging rate. When using either the single-rate method or the dual-rate method, managers can allocate supportdepartment costs to operating divisions based on either a budgeted rate or the eventual actual cost rate (Datar and Rajan, 2018: 622).

Practical capacity is the amount that an entity can generate if the normal operating disruptions are considered.

The ability of the enterprises to produce the products or services that constitute the main activities is called capacity. The capacity term is classified into four different headings: theoretical capacity, practical capacity, normal capacity, and expected capacity.

Allocation Based on the Demand for (or Usage of) Materials-Handling Services

1. Single-Rate Method: This method uses a combined budgeted rate for fixed and variable costs.
2. Dual-Rate Method: When a company uses a dual-rate method, managers must select allocation bases for both variable and fixed-cost pools of the Material Management Division.

Allocation Based on the Supply of Capacity

When a company uses the practical capacity to allocate costs, the single-rate method allocates only the actual fixed-cost resources used by the Machining and Assembly Departments, while the dual-rate method allocates the budgeted fixed-cost resources to be used by the operating departments. Unused Materials Management Department resources are highlighted but usually not allocated to the departments.

Budgeted Versus Actual Rates

In both the single-rate and dual-rate methods, which we mentioned in the above section, the Porsuk enterprise uses budgeted rates to assign the costs of the support department. As an alternative method, actual rates can be used based on the support costs incurred during the period. This method is less common because of the level of uncertainty imposed on user departments. When allocations are made using budgeted rates, managers of departments to which costs are allocated know with certainty the rates to be used in that budget period. Users can then determine the amount of the service to request and -if company policy allows- whether to use the internal resource or an external vendor. In contrast, when actual rates are used for cost allocation, user department managers do not know the costs allocated to the departments until the end of the budget period (Datar and Rajan, 2018: 628). Budgeted rates also motivate the manager of a support department to increase efficiency. In the budget period, the support department carries the risk of negative cost variances, not the user departments. This is because user departments do not pay any costs or inefficiencies of supplier departments that cause actual rates to exceed budgeted rates. The supplier department manager will see the budgeted rates as negative if negative cost variances occur due to price increases beyond the control. Some organizations try to identify these uncontrollable factors and relieve the manager of the support department for these variances. In other organizations, the support department and the user department agree to share the risk of a large, uncontrollable increase in the prices of inputs used by the support department. This procedure avoids the risk being fully implemented either to the support department (as with budgeted rates) or to the user department (as with actual rates) (Datar and Rajan, 2018: 628). In both singlerate and dual-rate methods, the assign of variable costs is made on the basis of budgeted rates and actual usage. Since variable costs are direct and dependent on use, it is appropriate to charge as a function of actual usage. Furthermore, the allocation of variable costs based on budgeted use will not give any incentive to control the consumption of user departments to support services (Datar and Rajan, 2018: 628).

Process for Allocating Support Department Costs

The process involves the following steps (Eldenburgh and Wolcott, 2005: 301):

1. Explain the purpose of the allocation.
2. Identify support and operating department cost pools.
3. Assign costs to cost pools.
4. For each support department cost pool, choose an allocation base.
5. Choose and apply a method for allocating support department costs to operating departments.
6. If relevant, allocate support costs from the operating departments to units of goods or services.

Identifying Support and Operating Department Cost Pools

A cost pool is a collection of costs to be assigned to a set of cost objects.

Many organizations already accumulate costs by the department within their organizational structure, departments are often used as cost pools. Larger organizations usually have more support departments that provide specific services. In smaller organizations, the purchasing function may be performed by a single person in the administration department who may also be responsible for several other functions, such as preparing the paperwork for hiring a new employee and making copies of reports for meetings (Eldenburgh and Wolcott, 2005: 302). The choice of cost pools is also influenced by the design of the accounting system. Some organizations have detailed accounting systems from which accountants can readily extract different kinds of costs for different purposes. If an accountant wants to allocate only purchasing costs, the time and effort involved in isolating those costs might exceed the benefit. Sometimes fixed and variable support costs are allocated separately. If fixed and variable costs have not been assigned to separate cost pools in the accounting system, then it might be timeconsuming and costly to separately allocate them. Another factor influencing the number and typeof support department cost pools is the ability to identify an appropriate allocation base. When too many different types of costs are pooled together, the allocation of costs becomes more arbitrary (Eldenburgh and Wolcott, 2005: 302) As a result, more accurate cost allocations can be achieved by separating support costs into a larger number of cost pools. Nevertheless, as the number of support cost pools increases, the cost of collecting information also increases. Thence, we face trade-offs when choosing the number of support cost pools for an organization (Eldenburgh and Wolcott, 2005: 302).

Assigning Costs to Cost Pools

Assigning Costs to Cost Pools Once the cost pools are identified, costs are assigned to them. Many costs can be directly traced. For example, employee salaries and supplies can be directly traced to individual departments. Facility costs include property insurance, utilities, property taxes, and maintenance and are often traced to a cost pool that is then allocated among all of the support and operating departments. Sometimes an employee provides services to more than one department. In such cases, employee wages are allocated to each department that receives the employee’s services. Judgment is often required in deciding which costs belong to which cost pools and in making estimations when costs must be allocated among cost pools (Eldenburgh and Wolcott, 2005: 302).

Choosing Allocation Bases

A cause and effect relationship is desirable between the support costs and the allocation base that is used to allocate them. Thus, the best allocation base is a cost driver. For example, in a hospital, pounds of laundry would be an appropriate cost driver for the laundry department because costs increase as the pounds of laundry increase. However, it may be difficult to find an appropriate cost driver if the department cost pool includes a number of different activities. In these cases, an allocation base is chosen to reflect some of the activities provided. If the accounting department employees track the time they spend on activities for all other departments, time spent would be an appropriate allocation base (Eldenburgh and Wolcott, 2005: 303). The cost of obtaining accurate allocation base information is an equally important consideration. Tracking time spent on different activities may cost more than the benefit gained from using it as an allocation base. As a result, accountants often use less accurate allocation bases for which data are available. Exhibit 4.3 on page 91, presents a list of support departments and possible allocation bases.

Allocating Costs of Multiple Support Departments

Direct Method

The direct allocation method (often called the direct method) is the most widely used method of allocating support department costs. This method allocates each support department’s costs directly to the operating departments. In this method costs accumulated in service departments are allocated to the manufacturing departments depending on the services that each of the manufacturing department requires from each of the service department. In this method, firstly, we have to identify the service carried out by each of the service department. Exhibit 4.5 illustrates this method using the data in Exhibit 4.4., on page 93.

Note how this method ignores both the 1,600 hours of support time rendered by the Plant Maintenance Department to the Information Systems Department and the 200 hours of support time rendered by Information Systems to Plant Maintenance. The base used to allocate Plant Maintenance is the budgeted total maintenance labor-hours worked in the operating departments: 2,400 + 4,000 = 6,400 hours. This amount excludes 1,600 hours of support time provided by Plant Maintenance to Information Systems. Similarly, the base used for allocation of Information Systems costs is 1,600 + 200 = 1,800 hours of computer time, which excludes the 200 hours of support time provided by Information Systems to Plant Maintenance (Bhimani, Horngren, Datar and Rajan, 2015, 134). The benefit of the direct method is its simplicity. There is no need to predict the usage of support department resources by other support departments. As a result, the direct method as illustrated in Figure 4.2., on page 93.

Step-down Method

In this method, the cost of service departments will be allocated to other service and operating departments depending on whether they provide services or not. In the method, first of all, the support departments should be ranked in the order that the step-down allocation will continue. The costs in the support department identified in the first-ranked are allocated to other support departments and operating departments in the ratio of their services. The costs in the second-ranked support department are allocated to support departments and business departments that have not yet been allocated. What is important here is that it does not return to the previously allocated support departments and does not give a share. This procedure is followed until the costs in the last-ranked support department are allocated to operating departments.

Reciprocal Method

This method is also known as algebraic method. The reciprocal allocation method allocates costs by explicitly including the mutual services provided among all support departments. Theoretically, the direct method and the stepdown method are less accurate when support departments provide services to one another reciprocally. For example, the Plant Maintenance Department maintains all the computer equipment in the Information Systems Department. Similarly, Information Systems provides database support for Plant Maintenance. The reciprocal allocation method enables us to incorporate interdepartmental relationships fully into the support department cost allocations. That is, Plant Maintenance is allocated to Information Systems and Information Systems is allocated to Plant Maintenance; each is allocated to the operating departments as well.

The reciprocal method, while conceptually preferable, is not widely used. The advantage of the direct and stepdown methods is that they are relatively simple to calculate and understand. However, with the ready availability of computer software to solve sets of simultaneous equations, the extra costs of using the reciprocal method will, in most cases, be minimal. The more likely obstacles to the reciprocal method are being widely adopted are: (1) many managers find it difficult to understand, and (2) the numbers obtained by using the reciprocal method differ little (in some cases) from those obtained by using the direct or step-down method. In the UK, the direct method is the most widespread (Bhimani, Horngren, Datar and Rajan, 2015, 138).

The advantage of the direct and step-down methods is that they are relatively simple to calculate and understand. However, with the ready availability of computer software to solve sets of simultaneous equations, the extra costs of using the reciprocal method will, in most cases, be minimal.