Support Activity and Dual Rate Allocations

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Chapter 16
Support Activity and Dual Rate Allocations
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Line and Support Activities

• A line activity is directly connected with making
  or selling a product
• Machining, distribution
• A support activity is needed to run the business
  (helps a line activity)
• Not connected directly to making or selling a
  product
• Human resources, accounting
• Need to allocate costs of both line and staff
  activities to products

LO1 Distinguish between line activities and
support activities
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What Is The Problem?

• Most allocations are two-stage systems
• We group costs into pools (stage 1). Pools can be
  departments, activities,.
• We allocate from pools to cost objects (stage 2)
• We have implicitly assumed (see next slide) a
  simple flow of costs (i.e., assume line
  activities only)
• In reality, the pattern of resource consumption
  could be complex (support activities exist)
• How should we account for this complexity in cost
  flows?

LO1 Distinguish between line activities and
support activities
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A Simple Two-Stage Allocation
LO1 Distinguish between line activities and
support activities
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A Complex System
LO1 Distinguish between line activities and
support activities
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Available Options

• There are three methods that we could use
• Direct method
• Step down method
• Reciprocal method
• Methods increase in accuracy from direct to step
  down to reciprocal
• The number of computations needed also increases
• Spreadsheets make step-down method easy to
  implement
• Standard accounting software allows us to
  implement the reciprocal method

LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Test Your Knowledge!
Which of the following methods is not an
acceptable method for allocating the cost of
support activities?

1. The step-down method
2. The reciprocal method
3. The indirect method
4. The direct method

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Data for Example
LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Direct Method

• This method ignores any interaction among the
  cost pools for support activities
• Note that cost pools for primary activities only
  go to the cost objects (by definition)
• Do the allocation as if the support departments
  did not consume any output from another service
  department
• Computation
• Re calculate the consumption percentages ignoring
  any consumption among support departments
• Allocate costs as before

LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Direct Method
LO2 Explain the three methods used to allocate
the costs of support activities to products.
11
Direct Method Computations
LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Test Your Knowledge!
In a home construction company, support costs
accumulated by the IT department can be allocated
to all except which of the following departments
when using the direct method?

1. Design
2. Electrical
3. Masonry
4. Purchasing

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After eliminating consumption by administration,
plumbing consumes 42.5 / 85.0 50 of the
purchasing activity and the Structural Department
consumes 25.5 / 85.0 30 of the purchasing
activity. Direct consumption by contracts
accounts for the remainder of 20.
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The Step-down method

• Concept
• Takes some account of interactions
• Rank order support departments per some criterion
  (usually size)
• Allocate from S1 to all others (including S2,
  S3)
• S2 cost now includes own cost plus cost allocated
  from S1
• Allocate from S2 to remaining departments (S3,)
• In this way, we close out one support pool at
  each step

LO2 Explain the three methods used to allocate
the costs of support activities to products.
15
Step Down Method
LO2 Explain the three methods used to allocate
the costs of support activities to products.
16
Step-down Method Computations
LO2 Explain the three methods used to allocate
the costs of support activities to products.
17
Step-down method

• Also known as the sequential method
• Departments are sequentially allocated
• The ordering of support departments matters
• Incentives to be strategic when choosing the
  order
• Can change amount allocated to segments with
  cost-based reimbursements

LO2 Explain the three methods used to allocate
the costs of support activities to products.
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The Reciprocal Method

• Conceptually most accurate
• Takes all linkages into account
• Views the allocation problem as a system of
  equations
• Uses matrix algebra to solve
• Easily implemented with modern computer packages
• Makes interpretation of rates quite hard, however
• The rate from S1 includes cost from S2, S3 etc,
  each of which has costs from S1!
• This circularity has the potential to confuse the
  casual user

LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Reciprocal Method Linkages
LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Mechanics

• Set up system of equation
• A 650,000 0.10 P
• P 250,000 0.30 A.
• We solve this system of equations by substituting
  the second equation into the first equation.
• A 719,895, P 465,969
• Can use Excel for more complex systems

LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Reciprocal Method Computations
LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Predetermined Overhead Rates

• Support allocations can be integrated with
  overhead rates
• Suppose
• 719,895 allocated from admin cost pool under
  reciprocal method
• SAC has 300 employees (incl. 8 in administration)
• Net 292 employees for the allocation
• Rate 719,895 / 292 2,465 per head
• Managers of the other line and support activities
  would be charged 2,465 as the cost of
  administration for each employee assigned to
  them

LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Why Integrate?

• Helps sensitize managers that support services
  are not free
• Provides incentives to control the driver
  quantity and thereby the allocated cost
• Try to make do with fewer employees
• The allocation is often seen as arbitrary
• Driver quantity and rate are often not
  controllable
• Lack of transparency in the system
• Why allocate 719,895 when cost is only 650,000?

LO2 Explain the three methods used to allocate
the costs of support activities to products.
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Solution presented in next slide.
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Solution for Check It Exercise 2

• There is no need to revise the pattern for
  purchasing as we allocate costs to all units that
  consume this activity. The revised consumption
  pattern from administration (28 / 70) 40
  for plumbing and (14 / 70) 20 for contracts.
  
• Costs allocated from purchasing are (0.15 x
  250,000) 37,500 to administration, 106,250
  to plumbing, and 42,500 directly to contracts.
  The total cost in administration is now37,500
  650,000 687,500.
• From administration, we therefore allocate 0.4 x
  687,500 275,000 each to structural and
  plumbing, and (0.20 x 687,500) 137,500
  directly to contracts. The final totals are
  1,373,750 for structural, 1,640,000 for
  plumbing, and 528,750 for contracts.

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Solution presented in next slide.
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Solution for Check It Exercise 3

• Under the direct method, total cost is 250,000
  (Exhibit 16.5) and the denominator volume is 850
  orders (1,050 - 50 for self-consumption - 150 for
  administration). Thus, the rate per order is
  294.12 (rounded).
• For the step-down method, the cost in the pool is
  445,000 (Exhibit 16.7). Because we only allocate
  these costs to structural, plumbing, and
  contracts, the denominator volume is 255 425
  170 850 orders. Thus, the rate is 523.53 per
  order (rounded).
• The denominator volume for the reciprocal method
  is 1,000 orders (we include the 150 orders from
  administration as we allocate costs back to
  administration). The rate is 465,968 / 1,000
  orders 465.97 per order.

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DUAL RATE ALLOCATIONS
LO3 Explain the need for dual rate allocations
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Why Needed?

• Incorporates the cost hierarchy into the
  allocations
• The cost pool for a department might contain
  unit, batch, product and facility level costs
• Separate them into distinct pools and choose
  suitable drivers
• In practice,
• Only two pools are made Fixed and variable costs
• Variable costs allocated based on actual use
  patterns
• Fixed costs (capacity costs) allocated based on
  long-term use patterns

LO3 Explain the need for dual rate allocations
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Example

• Total cost of printing 125 number of prints
• But, if allocated at this rate, we might
  under-utilize printing
• User-manager sees controllable cost as 125!
• But, only 50 per print might be controllable in
  the short-term
• A better allocation
• 112,500 50 per actual print ordered
• 112,500 is a lump-sum allocation based on
  long-term demand
• 50 per print is a variable cost incurred because
  of transaction

LO3 Explain the need for dual rate allocations
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Why Separate?

• We can send clear signals re the costs
  controllable over the differing horizons
• Decisions regarding service use (which
  user-department managers control) based on more
  relevant data
• The cost is system become more complex.
• Incentives to game the long-term estimate
• Under-estimate will lower lump sum allocation to
  user department
• Affects the amount of capacity to install

LO3 Explain the need for dual rate allocations
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Exercise 16.21
Direct method (LO2). The City of Pleasantville
has two departments Parks and Recreation (PR)
and Facility Maintenance (FM)that provide
services to its citizens. The PR Department
offers many programs in art, culture, and
athletics, while the FM Department maintains all
of the streets, buildings, and other public
facilities. Behind the scenes, Pleasantville has
two departments that support the activities of
the PR and FM departments. The Human Resources
Department processes payroll and oversees all
hiring, development, and training. The General
Administration Department provides overall
coordination and managerial support. The
following table provides data regarding the
consumption of services by the various activity
pools/departments, as well as the amount of costs
traced to each activity pool.
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Exercise 16.21 (Continued)
Direct method (LO2). The following table
provides data regarding the consumption of
services by the various activity
pools/departments, as well as the amount of costs
traced to each activity pool.
Required Allocate the costs of the two support
departments to the line departments, using the
direct method. Compute the total costs in the
cost pool for the PR and FM departments.
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Exercise 16.21 (Continued)
The key idea in the direct allocation method is
that we do not allocate costs from one support
department to another support department. Thus,
we could think of the direct method in two steps.
First, compute the allocation percentages,
ignoring the services provided to other support
departments. Second, perform the allocations.
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Exercise 16.21 (Continued)
In this exercise, we have two support
departments Human Resources and General
Administration. Thus, for step 1, we have
Human Resources General Administration Parks and Recreation Facilities Maintenance
Services Provided by   Human Resources1 50 50
Services Provided by   General Administration2 75 25
1 50 (30/60) where 60 is the total of the
support provided to non-service-
pools/departments. 2 75 (60/80) where 80 is
the total of the support provided to non-service-
pools/departments likewise for the FM department.
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Exercise 16.21 (Concluded)
We can now perform the second step allocate
costs. We know that HR has 100,000 and GA has
60,000 in costs. Thus, we have
Human Resources General Admin. Parks and Recreation Facilities Maintenance
Traced costs 100,000 60,000 360,000 450,000
Costs allocated from   Human Resources1 (100,000) 50,000 50,000
Costs allocated from   General Administration2 (60,000) 45,000 15,000
Total 0 0 455,000 515,000
1 50,000 0.50 100,000. 2 45,000 0.75
60,000.
After the allocation, we have 455,000 in PR and
515,000 in the FM department. The total amount
in these two pools is 970,000, the total
overhead that we began with for the four cost
pools.