Chap 15

Garrison−Noreen−Brewer: 15.
Service Department Text © The McGraw−Hill

Managerial Accounting, Costing: An Activity Companies, 2006
11th Edition Approach
C h a p t e r
Service Department
15 LEARNING OBJECTIVES
Costing: An Activity
Approach
After studying Chapter 15, you should be able to:
LO1 Allocate service department costs to other departments, using the

direct method.
LO2 Allocate service department costs to other departments, using the

step method.
LO3 Allocate variable and fixed service department costs separately at

the beginning of a period and at the end of the period.
Garrison−Noreen−Brewer: 15. Service Department Text © The McGraw−Hill
What Difference Does It Make?
P
rior to 1995, Boeing billed internal organizational units for their phone usage using 29 dif-
ferent rates that reflected how much of each type of service was used, such as interna- BUSINESS FOCUS
tional long distance, domestic long distance, and voice mailboxes. In 1995, this system
was replaced by a much simpler system in which all of the costs of voice services were al-
located to units based on the number of salaried employees. The rate in 1995 was $76.84 per
salaried employee per month; by 1998, the rate had increased to $91.84. A department with 10
salaried employees would therefore be charged $918.40 per month for voice services regardless
of how many phone lines were in use, how many long distance phone calls were made, or how many
voice mailboxes were in use. The simplified billing was thought to save Boeing several million dollars
a year in administrative costs. However, managers complained about the new system for several
reasons. First, the new billing system removed any incentives to economize on the use of voice ser-
vices. Purchases of cell phones more than doubled and long distance usage outpaced the growth in
employees. Second, some managers complained that the new system overcharged them for voice
services and did not provide any way for them to reduce phone costs other than to reduce the num-
ber of salaried employees. A manager who tried to control the use of long distance calling in his or
her department would find that those efforts had absolutely no effect on how much the department
was charged for voice services.
Boeing abandoned its simplified billing system in 1999, returning to a system that charged for
voice services actually used. ■
Source: William R. Ortega, “Alternative Chargeback Systems for Shared Services at the Boeing Company: The Case of Voice
Telecommunication Services,” Management Accounting Section 2001 Research and Case Conference, Institute of Manage-
ment Accountants, January 18–20, 2000.
718 Chapter 15 Service Department Costing: An Activity Approach
ost large organizations have both operating departments and ser-
M
Suggested Reading
Several Statements issued by the vice departments. The central purposes of the organization are carried out in
Institute of Management the operating departments. In contrast, service departments do not di-
Accountants, Montvale, New Jersey rectly engage in operating activities. Instead, they provide services or assis-
(www.imanet.org), deal with service
tance to the operating departments. Examples of operating departments include the
department cost allocations. See
Statement Number 4B, Allocation of
Surgery Department at Mt. Sinai Hospital, the Geography Department at the University
Service and Administrative Costs;
of Washington, the Marketing Department at Allstate Insurance Company, and production
Statement Number 4F, Allocation of departments at manufacturers such as Mitsubishi, Hewlett-Packard, and Michelin. Exam-
Service Department Costs; and ples of service departments include Cafeteria, Internal Auditing, Human Resources, Cost
Statement Number 4G, Accounting Accounting, and Purchasing.
for Indirect Production Costs. Service department costs are allocated to operating departments for a variety of rea-
sons including:
• To encourage operating departments to make wise use of service department re-
sources. If the services were provided for free, operating managers would be inclined
to waste these resources.
• To provide operating departments with more complete cost data for making deci-
sions. Actions taken by operating departments have impacts on service department
costs. For example, hiring another employee will increase costs in the human re-
sources department. Such service department costs should be charged to the operat-
ing departments, otherwise the operating departments will not take them into account
when making decisions.
• To help measure the profitability of operating departments. Allocating service de-
partment costs to operating departments provides a more complete accounting of the
costs incurred as a consequence of activities in the operating departments.
• To create an incentive for service departments to operate efficiently. Allocating ser-
vice department costs to operating departments provides a system of checks and bal-
ances in the sense that cost-conscious operating departments will take an active
interest in keeping service department costs low.
• To value inventory for external financial reporting purposes. Generally Accepted Ac-
counting Principles (GAAP) require that all manufacturing overhead costs be as-
signed to products. Allocating service department costs to operating departments
ensures that these manufacturing overhead costs are included in the operating de-
partments’ overhead rates, which are used to apply costs to products.
• When cost-plus pricing is used, service department costs are commonly allocated to
the operating departments so as to include these costs in the cost base.
Several different allocation methods will be considered in this chapter. The method
that is selected can have a significant impact on the computed costs of goods and services
and can affect an operating department’s performance evaluation.
Allocations
Allocations Using the Direct Using
and Step the Direct and Step Methods
Methods
Suggested Reading All allocations require the use of an allocation base. We have discussed the principles in-
In regulated industries, allocation volved in selecting an allocation base in earlier chapters, but those principles are worth
bases are often selected to mitigate repeating.
the effects of regulations. See Ken S.
Cavalluzzo, Christopher D. Ittner, and
David F. Larcker, “Competition, Selecting Allocation Bases
Efficiency, and Cost Allocation in
Government Agencies: Evidence on An allocation base should “drive” the cost that is being allocated. For example, when allo-
the Federal Reserve System,” Journal cating the costs of the employee cafeteria, the number of meals served would be a good
of Accounting Research 36, no. 1, choice for the allocation base. Many of the costs of the cafeteria, such as the costs of ingre-
Spring 1998, pp. 1–32, for an dients used, are driven by how many meals are served. Ideally, all of the costs that are be-
interesting example. ing allocated should be driven by the allocation base in the sense that the costs being
Chapter 15 Service Department Costing: An Activity Approach 719
EXHIBIT 15–1
Service Department Allocation Bases
Examples of Bases Commonly
Laundry Pounds of laundry Used to Allocate Service
Airport Ground Services Number of flights Department Costs
Cafeteria Number of meals
Medical Facilities Cases handled; number of employees;
hours worked
Materials Handling Hours of service; volume handled
Information Technology Number of personal computers; applications
installed
Custodial Services Square footage occupied
Cost Accounting Labor-hours; customers served
Power KWH used; capacity of machines
Human Resources Number of employees; training hours
Receiving, Shipping, and Stores Units handled; number of requisitions;
space occupied
Factory Administration Total labor-hours Instructor’s Note
Maintenance Machine-hours Ask students if they ever worked in a
large organization where the charges
of service departments seemed
allocated are directly proportional to the allocation base. For example, if the number of exorbitant. (At one of the authors’
meals served increases (or decreases) by 10%, then the total cost of the employee cafeteria universities, the university’s paint
should also increase (or decrease) by 10%. Managers also often argue that an allocation base shop charges several times the going
should reflect as accurately as possible the benefits received from the service department. market rate to paint a faculty office.)
For example, most managers would argue that the appropriate allocation base for jan- Then ask students why this happens.
Often the reason is that internal work
itorial services is the square feet of building space occupied by each department because
charges include arbitrary allocations
both the costs and benefits of janitorial services tend to be proportional to the amount of
of fixed administrative overhead and
space occupied by a department. Examples of allocation bases for some service depart- an allowance for the fixed costs of
ments are listed in Exhibit 15–1. Note that a given service department’s costs may be al- the service department itself. This
located using more than one base. For example, the costs of a human resources creates a spiraling effect. Since the
department might be divided into two parts, with one part allocated on the basis of the charges are so high, demand falls
number of employees in each department and the other part allocated on the basis of and the rates are pushed even
hours spent in training programs run by the human resources department. higher.
INCREASING ACCURACY AT HUGHES AIRCRAFT IN BUSINESS

For many years, Hughes Aircraft allocated service department costs to operating departments us-
ing headcount as the allocation base. This method, while simple, was inaccurate because most ser-
vice department costs are not driven by the number of employees (i.e., headcount) in the operating
departments. To overcome this problem, the company adopted an activity-based approach in which
each service department’s costs are allocated based on the activities that are believed to drive the
service department’s costs. For example, the costs of the Human Resources Department are now
allocated on the basis of headcount, new hires, union employees, and training hours in each oper-
ating department. Operating managers can control the amount of Human Resources cost allocated
to their departments by controlling headcount, number of new hires, number of union employees,
and number of training hours in their departments.
Source: Jack Haedicke and David Feil, “Hughes Aircraft Sets the Standard for ABC,” Management Accounting
72, no. 8, pp. 31–32.
Interdepartmental Services
Many service departments provide services to each other, as well as to operating depart- LEARNING OBJECTIVE 1
ments. The Cafeteria Department, for example, provides food for all employees, including Allocate service department
those assigned to other service departments. In turn, the Cafeteria Department may receive costs to other departments,
services from other service departments, such as from Custodial Services or from Person- using the direct method.
nel. Services provided between service departments are known as interdepartmental or
reciprocal services.
Reinforcing Problems Three approaches are used to allocate the costs of service departments to other de-
Learning Objective 1 partments. These are known as the direct method, the step method, and the reciprocal
Exercise 15–1 Basic 15 min. method. These three methods are discussed in the following sections.
Exercise 15–6 Basic 20 min.
Problem 15–10 Basic 60 min.
Case 15–17 Difficult 90 min. Direct Method The direct method is the simplest of the three cost allocation meth-
Case 15–18 Difficult 75 min. ods. It ignores the services provided by a service department to other service departments
and allocates all of its costs directly to operating departments. Even if a service depart-
ment (such as Personnel) provides a large amount of service to another service depart-
ment (such as the cafeteria), no allocations are made between the two departments.
Rather, all costs are allocated directly to the operating departments, bypassing the other
service departments. Hence the term direct method.
IN BUSINESS
A LOSING FOOTBALL PROGRAM
At Georgia Tech, service department costs are allocated to intercollegiate sports programs using
the direct method. For example, the costs of the Sports Medicine Department are allocated on
the basis of the number of student athletes in each intercollegiate sport. Some costs, such as a
sport’s operating budget, recruiting costs, scholarships, and salaries, can be traced directly to
the sport and are called direct costs. Service department costs, which are allocated, include
Sports Medicine, Facilities, Sports Information, Academic Center, Student-Athlete Program, Office
Supplies, Legal and Audit, Accounting Office, Marketing, and Administrative. Allocations of these
service department costs to the sports programs can make a big difference in their apparent
profitability. For example, the football program shows a margin of over $1 million based on just
its direct costs, but a loss of over $800,000 when service department costs are allocated to the
program.
Source: C. David Strupeck, Ken Milani, and James E. Murphy III, “Financial Management at Georgia Tech,” Man-
agement Accounting 74, no. 8, pp. 58–63.
For an example of the direct method, consider Mountain View Hospital, which has
two service departments and two operating departments as shown below:
Suggested Reading
James B. Stinson illustrates
how spreadsheets can be used for Service Operating
direct method, step method, and Departments Departments
reciprocal method allocations of Hospital Custodial Patient
service department costs to Administration Services Laboratory Care Total
operating departments in “Cost
Allocation—From the Simple to the Departmental
Sublime,” Management Accounting costs before
Quarterly, Fall 2002, pp. 1–10. allocation . . . . $360,000 $90,000 $261,000 $689,000 $1,400,000
Employee hours. . 12,000 6,000 18,000 30,000 66,000
Instructor’s Note
Space occupied—
What to include in the allocation base
square feet . . . 10,000 200 5,000 45,000 60,200
under the direct method often
confuses students. For example, if
personnel department costs are
allocated on head count, should the Hospital Administration costs will be allocated on the basis of employee-hours and
Personnel Department head count Custodial Services costs will be allocated on the basis of square feet occupied.
and that of other service departments The direct method of allocating the hospital’s service department costs to the operat-
be included? While it doesn’t seem to ing departments is shown in Exhibit 15–2. Several things should be carefully noted in this
make much sense economically, the exhibit. First, the employee-hours of the Hospital Administration Department and the
service departments must Custodial Services Department are ignored when allocating the costs of Hospital Admin-
be excluded so as to Topic Tackler
istration using the direct method. Under the direct method, any of the allocation base at-
avoid allocating costs
tributable to the service departments themselves is ignored; only the amount of the
back to the service
allocation base attributable to the operating departments is used in the allocation. Note
departments. PLUS
that the same rule is used when allocating the costs of the Custodial Services Department.
15–1
EXHIBIT 15–2
Direct Method of Allocation
Service Operating
Departments Departments
Hospital Custodial Patient
Administration Services Laboratory Care Total
Departmental costs before allocation . . . . . . . . . $360,000 $90,000 $261,000 $689,000 $1,400,000
Allocation:
Hospital Administration costs (18 ⁄48, 30⁄48)* . . . . . (360,000) 135,000 225,000
Custodial Services costs (5⁄ 50, 45 ⁄ 50)† . . . . . . . . (90,000) 9,000 81,000
Total costs after allocation . . . . . . . . . . . . . . . . . . $ 0 $ 0 $405,000 $995,000 $1,400,000
*Based on the employee-hours in the two operating departments, which are 18,000 hours ⫹ 30,000 hours ⫽ 48,000
hours.
†
Based on the square feet occupied by the two operating departments, which is 5,000 square feet ⫹ 45,000 square feet
⫽ 50,000 square feet.
Even though the Hospital Administration and Custodial Services departments occupy LEARNING OBJECTIVE 2
some space, this is ignored when the Custodial Services costs are allocated. Finally, note Allocate service department
that after all allocations have been completed, all of the service department costs are con- costs to other departments,
tained in the two operating departments. using the step method.
Although the direct method is simple, it is less accurate than the other methods since
it ignores interdepartmental services. Reinforcing Problems
Learning Objective 2
Step Method Unlike the direct method, the step method provides for allocation of a Exercise 15–2 Basic 15 min.
service department’s costs to other service departments, as well as to operating depart- Exercise 15–5 Basic 20 min.
ments. The step method is sequential. The sequence typically begins with the department Problem 15–10 Basic 60 min.
that provides the greatest amount of service to other service departments. After its costs Problem 15–13 Medium 45 min.
have been allocated, the process continues, step by step, ending with the department that Problem 15–15 Medium 60 min.
provides the least amount of services to other service departments. This step procedure is Problem 15–16 Medium 45 min.
illustrated in graphic form in Exhibit 15–3 (page 722). Case 15–18 Difficult 75 min.
Exhibit 15–4 (page 722) shows the details of the step method. Note the following Topic Tackler
three key points about these allocations. First, under the Allocation heading in Exhibit
15–4, you see two allocations, or steps. In the first step, the costs of Hospital Administra-
tion are allocated to another service department (Custodial Services) as well as to the op- PLUS
erating departments. In contrast to the direct method, the allocation base for Hospital
15–2
Administration costs now includes the employee-hours for Custodial Services as well as
for the operating departments. However, the allocation base still excludes the employee- Instructor’s Note
hours for Hospital Administration itself. In both the direct and step methods, any amount What to include in the allocation
of the allocation base attributable to the service department whose cost is being allocated base under the step method often
is always ignored. Second, looking again at Exhibit 15–4, note that in the second step un- confuses students. Never include in
der the Allocation heading, the cost of Custodial Services is allocated to the two operat- the allocation base the service
department whose cost is being
ing departments, and none of the cost is allocated to Hospital Administration even though
allocated; once a service
Hospital Administration occupies space in the building. In the step method, any amount
department’s cost has been
of the allocation base that is attributable to a service department whose cost has already allocated, pretend the department
been allocated is ignored. After a service department’s costs have been allocated, costs of doesn’t exist anymore. In other
other service departments are not reallocated back to it. Third, note that the cost of Cus- words, at each step allocate a
todial Services allocated to other departments in the second step ($130,000) in Exhibit service department’s cost to the
15–4 includes the costs of Hospital Administration that were allocated to Custodial Ser- remaining service departments and
vices in the first step in Exhibit 15–4. to all of the operating departments.
EXHIBIT 15–3
Hospital
Graphic Illustration—Step
Administration
Method
Costs are allocated to other
departments on the basis
of employee-hours.
Custodial
Services
Costs are allocated to

operating departments
on the basis of square
feet occupied.
Laboratory Patient Care
EXHIBIT 15–4
Step Method of Allocation
Service Operating
Hospital Custodial Patient
Administration Services Laboratory Care Total
Departmental costs before allocation . . . . . . . . . $360,000 $ 90,000 $261,000 $ 689,000 $1,400,000

Allocation:
Hospital Administration costs (6⁄ 54, 18⁄ 54, 30⁄ 54)* . (360,000) 40,000 120,000 200,000
Custodial Services costs (5⁄ 50, 45⁄ 50)† . . . . . . . . . (130,000) 13,000 117,000
Total costs after allocation . . . . . . . . . . . . . . . . . . $ 0 $ 0 $394,000 $1,006,000 $1,400,000
*Based on the employee-hours in Custodial Services and the two operating departments, which are 6,000 hours ⫹
18,000 hours ⫹ 30,000 hours ⫽ 54,000 hours.
†
As in Exhibit 15–2, this allocation is based on the square feet occupied by the two operating departments.
IN BUSINESS STEPPING DOWN AT GROUP HEALTH

Group Health Cooperative of Puget Sound is a large health maintenance organization with 500 ser-
vice departments that account for 30% of Group Health’s total costs. The step method is used to al-
locate these costs to patient care departments and then to patients. These allocations are done so
that costs can be summarized in a variety of ways including “by consumers, by diagnostic group-
ings, by employer groups, and by specific populations, such as Medicare, Medicaid, AIDS, Heart
Care, and so on.”
Source: John Y. Lee and Pauline Nefcy, “The Anatomy of an Effective HMO Cost Management System,” Man-
agement Accounting, January 1997, p. 52.
Reciprocal Method The reciprocal method gives full recognition to interdepart-

mental services. Under the step method discussed above only partial recognition of inter-
departmental services is possible. The step method always allocates costs forward—never
backward. The reciprocal method, by contrast, allocates service department costs in both Instructor’s Note
directions. Thus, since Custodial Services in the prior example provides services for Hos- Students may object to the
pital Administration, part of Custodial Services’ costs will be allocated back to Hospital inaccuracies of the step method. This
gives an opportunity to explain the
Administration if the reciprocal method is used. At the same time, part of Hospital Ad-
reciprocal method. Ask students
ministration’s costs will be allocated forward to Custodial Services. Reciprocal allocation
what would happen if every service
requires the use of simultaneous linear equations and is beyond the scope of this book. department’s costs were allocated to
Examples of the reciprocal method can be found in more advanced cost accounting texts. all of the service departments
The reciprocal method is rarely used in practice for two reasons. First, the computa- (including itself if appropriate).
tions are relatively complex. Although the complexity issue can be overcome by use of Someone should answer that some
computers, there is no evidence that computers have made the reciprocal method more costs would still be left in the service
popular. Second, the step method usually provides results that are close to the results that departments when the allocations are
the reciprocal method would provide. Thus, companies have little motivation to use the finished. Ask what would happen if
more complex reciprocal method. you started over and used the same
procedure to allocate the service
department costs that remain.
Revenue Producing Departments To conclude our discussion of allocation meth-
Someone should answer that some
ods, it is important to note that even though most service departments are cost centers and
costs would still be left in the service
therefore generate no revenues, a few service departments such as the cafeteria may departments, but the costs would be
charge for the services they perform. If a service department generates revenues, those less than before. In fact, if this
revenues should be offset against the department’s costs, and only the net amount of cost process is repeated many times until
remaining after this offset should be allocated to other departments. Otherwise, the other no costs are left in the service
departments would be charged for costs that have already been reimbursed. departments, you have essentially
performed a reciprocal allocation.
Allocating Costs by Behavior Allocating Costs by Behavior

Whenever possible, variable and fixed service department costs should be allocated sep- Suggested Reading
arately to provide more useful data for planning and control of departmental operations. Robert S. Kaplan offers insightful
discussions of service department
cost allocation in “Assigning Support
Variable Costs Department Expenses to Production
Cost Centers (A),” Harvard Business
Variable costs vary in total in proportion to changes in the level of service provided. For School Cases, 1996, pp. 1–7; and
example, the cost of food in a cafeteria is a variable cost that varies in proportion to the “Assigning Support Department
number of persons using the cafeteria or the number of meals served. Expenses to Production Cost
As a general rule, a variable cost should be charged to consuming departments ac- Centers (B): Flexible Budgets,”
cording to whatever activity causes the incurrence of the cost. For example, variable costs Harvard Business School Cases,
of a maintenance department that are caused by the number of machine-hours worked 1997, pp. 1–7.
in the operating departments should be allocated to the operating departments using
machine-hours as the allocation base. This will ensure that these costs are properly traced
to departments, products, and customers.
Fixed Costs
The fixed costs of service departments represent the costs of making capacity available
for use. These costs should be allocated to consuming departments in predetermined
lump-sum amounts. By predetermined lump-sum amounts we mean that the total amount
charged to each consuming department is determined in advance and, once determined,
does not change. The lump-sum amount charged to a department can be based either on
the department’s peak-period or long-run average servicing needs. The logic behind
lump-sum allocations of this type is as follows:
When a service department is first established, its capacity will be determined by the
needs of the departments that it will serve. This capacity may reflect the peak-period needs
of the other departments, or it may reflect their long-run average or “normal” servicing
needs. Depending on how much servicing capacity is provided for, it will be necessary to
make a commitment of resources, which will be reflected in the service department’s fixed
costs. These fixed costs should be borne by the consuming departments in proportion to
the amount of capacity each consuming department requires. That is, if available capacity
in the service department has been provided to meet the peak-period needs of consuming
departments, then the fixed costs of the service department should be allocated in prede-
termined lump-sum amounts to consuming departments on that basis. If available capac-
ity has been provided only to meet “normal” or long-run average needs, then the fixed
costs should be allocated on that basis.
Once set, allocations should not vary from period to period, since they represent the
cost of having a certain level of service capacity available and on line for each consum-
ing department. The fact that a consuming department does not need the peak level or
even the “normal” level of service every period is immaterial; the capacity to deliver this
level of service must be available. The consuming departments should bear the cost of
that availability.
To illustrate this idea, assume that Novak Company has just organized a Maintenance
Department to service all machines in the Cutting, Assembly, and Finishing Departments.
In determining the capacity of the newly organized Maintenance Department, the various
operating departments estimated that they would have the following peak-period needs
for maintenance:
Peak-Period Maintenance
Needs in Terms of Number Percent
of Hours of Maintenance of Total
Department Work Required Hours
Cutting . . . . . . . . . . . . . . . . 900 30%
Assembly . . . . . . . . . . . . . . 1,800 60
Finishing . . . . . . . . . . . . . . 300 10
3,000 100%
Suggested Reading
Tony Scrace and Laurie McAulay
investigate the service department Therefore, in allocating the Maintenance Department fixed costs to the operating
charges at one company in departments, 30% (i.e., 900/3,000 ⫽ 30%) should be allocated to the Cutting Department,
“Recharging service costs in
60% to the Assembly Department, and 10% to the Finishing Department. These lump-
financial services: is there an
sum allocations will not change from period to period unless peak-period servicing needs
optimum charge?” Management
Accounting (U.K.), February 1997,
change.
pp. 40–42. The company in their
study violates several of the Should Actual or Budgeted Costs Be Allocated?
guidelines in this chapter, apparently
in the belief that its method of Should the actual or budgeted costs of a service department be allocated to operating de-
charging for service department partments? The answer is that budgeted costs should be allocated because allocating ac-
costs creates pressure to cut tual costs would burden the operating departments with any inefficiencies in the service
those costs. department. In other words, if actual costs are allocated, any lack of cost control on the
Instructor’s Note part of the service department is simply buried in a routine allocation to other departments.
Ask students why it is better to Any variance over budgeted costs is the responsibility of the service department. The
charge managers a lump sum for variance should be retained in the service department and closed out at year-end against
access to service departments the company’s revenues or against cost of goods sold, along with other variances. Oper-
rather than including a “markup” for ating department managers justifiably complain bitterly if they are forced to absorb ser-
fixed costs in the charge for the use vice department inefficiencies.
of services. The answer is that if the Technically, preset charges based on budgeted costs are not allocations. Instead of di-
charge for the use of services viding actual costs among the operating departments, they are charged a fixed amount per
exceeds variable cost and excess
unit of service provided. In effect, management says, “You will be charged X dollars for
capacity exists, managers will
every unit of service that you consume or capacity that you require. You can consume as
demand too little of the service from
the standpoint of the company as a
much or as little as you desire; the total charge you bear will vary proportionately.” The
whole. This discussion can be used purpose of making such charges is to ensure that the managers of the operating depart-
to reinforce ideas developed when ments are fully aware of all of the costs of their actions—including costs that are incurred
covering transfer pricing, since this in service departments. This helps operating department managers make appropriate
is essentially a transfer pricing trade-offs when deciding, for example, whether to purchase a service from an external
problem. provider or to obtain it from a service department inside the company.
A Summary of Cost Allocation Guidelines

The following guidelines summarize the preceding discussion concerning allocations of
service department costs.
1. Variable and fixed service department costs should be allocated separately when
feasible.
2. Variable costs should be allocated at the budgeted rate, according to whatever activ-
ity (e.g., miles driven, direct labor-hours, number of employees) causes the incur-
rence of the cost.
a. If the allocations are being made at the beginning of the year, they should be
based on the budgeted activity level planned for the consuming departments. The
allocation formula is:
Variable cost allocated at the
⫽ Budgeted rate ⫻ Budgeted activity
beginning of the period
b. If the allocations are being made at the end of the year, they should be based
on the actual activity level that has occurred during the year. The allocation for-
mula is:
Variable cost allocated at the
⫽ Budgeted rate ⫻ Actual activity
end of the period
Allocations made at the beginning of the year provide data for pricing and other
decisions. Allocations made at the end of the year provide data for comparing actual
performance to planned performance.
3. Fixed costs represent the costs of having service capacity available. Where feasible,
these costs should be allocated in predetermined lump-sum amounts. The lump-sum
amount allocated to each department should be in proportion to the servicing needs
that gave rise to the fixed costs. (This might be either peak-period needs or long-run
average needs.) Budgeted fixed costs, rather than actual fixed costs, should always be
allocated.
Implementing the Allocation Guidelines

Specific examples will show how to implement the three guidelines given above. First, LEARNING OBJECTIVE 3
we focus on the allocation of costs for a single department, and then we provide a more Allocate variable and fixed
extended example involving multiple departments. service department costs
separately at the beginning of a
Basic Allocation Techniques Seaboard Airlines has two operating divisions: a period and at the end of the
Freight Division and a Passenger Division. The company has a Maintenance Department period.
that provides servicing to both divisions. Variable servicing costs are budgeted at $10 per
flight-hour. The department’s fixed costs are budgeted at $750,000 for the year. The fixed Reinforcing Problems
costs of the Maintenance Department are budgeted based on the peak-period demand, Learning Objective 3
which occurs during the Thanksgiving to New Year’s holiday period. The airline wants to Exercise 15–3 Basic 10 min.
make sure that none of its aircraft are grounded during this key period due to unavailabil- Exercise 15–4 Basic 20 min.
ity of maintenance facilities. Approximately 40% of the maintenance during this period is Exercise 15–7 Basic 20 min.
performed on the Freight Division’s equipment, and 60% is performed on the Passenger Exercise 15–8 Basic 15 min.
Division’s equipment. These figures and the budgeted flight-hours for the coming year are Exercise 15–9 Basic 15 min.
Problem 15–11 Basic 45 min.
as follows:
Problem 15–12 Medium 30 min.
Problem 15–13 Medium 45 min.
Percent of Peak Period Budgeted Problem 15–14 Medium 30 min.
Capacity Required Flight-Hours Problem 15–15 Medium 60 min.
Freight Division . . . . . . . . . . . . . . 40% 9,000 Problem 15–16 Medium 45 min.
Passenger Division . . . . . . . . . . . 60 15,000 Case 15–17 Difficult 90 min.
Total . . . . . . . . . . . . . . . . . . . . . . . 100% 24,000

Given these data, the amount of cost that would be allocated to each division from the
Maintenance Department at the beginning of the coming year would be as follows:
Division
Budgeted
activity Freight Passenger
Budgeted Variable cost allocation:
variable $10 per flight-hour ⫻ 9,000 flight-hours . $ 90,000
rate $10 per flight-hour ⫻ 15,000 flight-hours . $150,000
Fixed cost allocation:
40% ⫻ $750,000 . . . . . . . . . . . . . . . . . . . 300,000
Peak-period
60% ⫻ $750,000 . . . . . . . . . . . . . . . . . . . 450,000
capacity
required Total cost allocated . . . . . . . . . . . . . . . . . . . . . . $390,000 $600,000
Budgeted fixed cost
These allocated Maintenance Department costs would be included in the flexible budgets
of the respective divisions and included in the computation of divisional overhead rates.
At the end of the year, Seaboard Airlines’ management may want to make a second
allocation, this time based on actual activity, in order to compare actual performance for
the year against planned performance. To illustrate, year-end records show that actual
variable and fixed costs in the aircraft Maintenance Department for the year were
$260,000 and $780,000, respectively. One division logged more flight-hours during the
year than planned, and the other division logged fewer flight-hours than planned, as
shown below:
Flight-Hours
Budgeted
(see above) Actual
Freight Division . . . . . . . . . . 9,000 8,000
Passenger Division . . . . . . . 15,000 17,000
Total flight-hours . . . . . . . . . 24,000 25,000
The amount of actual Maintenance Department cost charged to each division for the year
would be as follows:
Division
Actual
activity Freight Passenger
Budgeted Variable cost allocation:
variable $10 per flight-hour ⫻ 8,000 flight-hours . $ 80,000
rate $10 per flight-hour ⫻ 17,000 flight-hours . $170,000
Fixed cost allocation:
40% ⫻ $750,000 . . . . . . . . . . . . . . . . . . . . 300,000
Peak-period
60% ⫻ $750,000 . . . . . . . . . . . . . . . . . . . . 450,000
capacity
required Total cost allocated . . . . . . . . . . . . . . . . . . . . . . $380,000 $620,000
Budgeted fixed cost
Notice that variable servicing costs are charged to the operating divisions based on the
budgeted rate ($10 per hour) and the actual activity for the year. In contrast, the charges for
fixed costs are exactly the same as they were at the beginning of the year. Also note that the
two operating divisions are not charged for the actual costs of the service department,
which may be influenced by inefficiency in the service department and may be beyond the
control of the managers of the operating divisions. Instead, the service department is held
responsible for the unallocated actual costs as shown below:
Variable Fixed
Total actual costs incurred $260,000 $780,000
Costs allocated (above) 250,000* 750,000
Spending variance—not allocated $ 10,000 $ 30,000
*$10 per flight-hour ⫻ 25,000 actual flight-hours ⫽ $250,000.
These variances will be closed out against the company’s revenues or cost of goods sold
for the year, along with any other variances that may occur.
Effect of
Effect of Allocations on Operating Allocations on Operating Departments
Departments
Once allocations have been completed, what do the operating departments do with the
allocated service department costs? The allocations are typically included in perfor-
mance evaluations of the operating departments and also included in determining their
profitability.
In addition, if the operating departments are responsible for developing overhead
rates for costing products or services, then the allocated costs are combined with the other
costs of the operating departments, and the total is used as the basis for rate computations.
This rate development process is illustrated in Exhibit 15–5.
The budget serves as the means for combining allocated service department costs
with operating department costs and for computing overhead rates. An example is pre-
sented in Exhibit 15–6 (page 728). Note from the exhibit that both variable and fixed ser-
vice department costs have been allocated to Superior Company’s Milling Department
and are included on the latter’s budget. Since allocated service department costs are an in-
tegral part of the budget, they are automatically included in overhead rate computations,
as shown at the bottom of the exhibit.
First Stage Second Stage EXHIBIT 15–5

Service department Operating department overhead Effect of Allocations on
costs are allocated to costs, plus allocated service depart- Products and Services
operating departments. ment costs, are applied to products
and services using departmental
overhead rates.
Service
department
(Cafeteria)
Operating
department
Service Product
department or service
(Cost Accounting) Operating
department
Service
department
(Personnel)
EXHIBIT 15–6
SUPERIOR COMPANY
Budget Containing Allocated
Budget—Milling Department
Service Department Costs
Budgeted direct labor-hours . . . . . . . . . . . . . . . . . . . 50,000
Cost Formula
(per direct
labor-hour) Overhead
Variable overhead costs:
Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.45 $ 72,500
Indirect material . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.90 45,000
Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.10 5,000
Allocation—Cafeteria . . . . . . . . . . . . . . . . . . . . . . . 0.15 7,500
Total variable overhead cost . . . . . . . . . . . . . . . . . . . $2.60 130,000
Fixed overhead costs:
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000
Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . 110,000
Property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000
Allocation—Cafeteria . . . . . . . . . . . . . . . . . . . . . . . 21,000
Allocation—Human Resources . . . . . . . . . . . . . . . 45,000
Total fixed overhead cost . . . . . . . . . . . . . . . . . . . . . . 270,000
Total overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000
$400,000
Predetermined overhead rate ⫽ ⫽ $8 per direct labor-hour
50,000 DLHs
An Extended Example An Extended Example

Proctor Company has three service departments—Building Maintenance, Cafeteria, and
Inspection. The company also has two operating departments—Shaping and Assembly.
The service departments provide services to each other, as well as to the operating depart-
ments. Types of costs in the service departments and allocation bases are given below:
Department Type of Cost Allocation Bases

Building Maintenance . . . . . . . . . . . Fixed costs Square feet occupied
Cafeteria . . . . . . . . . . . . . . . . . . . . . Variable costs Number of employees
Fixed costs 10% to Inspection,
40% to Shaping, and
50% to Assembly
Inspection . . . . . . . . . . . . . . . . . . . . Variable costs Direct labor-hours
Fixed costs 70% to Shaping and
30% to Assembly
Proctor Company allocates service department costs by the step method in the fol-
lowing order:
1. Building Maintenance.
2. Cafeteria.
3. Inspection.
Assume the following budgeted cost and operating data for the year:
Department Variable Cost Fixed Cost

Building Maintenance . . . . . . . . — $130,000
Cafeteria . . . . . . . . . . . . . . . . . . $200 per employee $250,000
Inspection . . . . . . . . . . . . . . . . . $0.06 per direct labor-hour $548,000
Direct
Number of Labor- Square Feet
Department Employees Hours Occupied
Building Maintenance . . . . . . . 6 — 3,000
Cafeteria . . . . . . . . . . . . . . . . . 9 — 4,000
Inspection . . . . . . . . . . . . . . . . 30 — 1,000
Shaping . . . . . . . . . . . . . . . . . 190 300,000 8,000
Assembly . . . . . . . . . . . . . . . . 250 500,000 13,000
Total . . . . . . . . . . . . . . . . . . . . 485 800,000 29,000
In addition to the service department costs listed above, the company’s Shaping Depart-
ment has budgeted $1,340,000 in overhead costs, and its Assembly Department has bud-
geted $1,846,000 in overhead costs.
Cost allocations from the service departments to the operating departments are
shown in Exhibit 15–7. In the first panel of Exhibit 15–7 (page 730), the variable costs
of the service departments are allocated using the step method and budgeted rates and
budgeted activity. For example, the variable cost of the Cafeteria Department is $200
per employee, so the Inspection Department, with 30 employees, is allocated $6,000 of
this variable cost. In the second panel of Exhibit 15–7, the fixed costs of the service de-
partments are allocated. Building Maintenance is allocated first using the square feet
occupied by each of the other departments as the allocation base. Then the fixed costs
of the Cafeteria and Inspection departments are allocated based on the given percent-
ages. After both the variable and fixed service department costs have been allocated, the
predetermined overhead rates for the two operating departments are computed toward
the bottom of the exhibit.
Some Cautions in Allocating ServiceinDepartment

Some Cautions Allocating Service Department Costs
Pitfalls in Allocating Fixed Costs
Rather than charge fixed costs to using departments in predetermined lump-sum amounts,
some companies allocate them using a variable allocation base that fluctuates from period
to period. This practice can distort decisions and create serious inequities between de-
partments. The inequities will arise from the fact that the fixed costs allocated to one de-
partment will be heavily influenced by what happens in other departments.
To illustrate, assume that Kolby Products has an auto service center that provides
maintenance work on the fleet of autos used in the company’s two sales territories. The
auto service center costs are all fixed. Contrary to good practice, the company allocates
these fixed costs to the sales territories on the basis of actual miles driven (a variable
allocation base). Selected cost data for the last two years follow:
Year 1 Year 2
Auto service center costs (all fixed) (a) . . . . . . . . . . . $120,000 $120,000
Western sales territory—miles driven . . . . . . . . . . . . 1,500,000 1,500,000
Eastern sales territory—miles driven . . . . . . . . . . . . . 1,500,000 900,000
Total miles driven (b) . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000 2,400,000
Allocation rate per mile, (a) ⫼ (b) . . . . . . . . . . . . . . . $0.04 $0.05
Notice that the Western sales territory maintained an activity level of 1,500,000 miles
driven in both years. On the other hand, activity in the Eastern sales territory dropped
from 1,500,000 miles in Year 1 to only 900,000 miles in Year 2. The auto service center
EXHIBIT 15–7
THE PROCTOR COMPANY

Beginning-of-Year Cost Allocations for Purposes of
Preparing Predetermined Overhead Rates
Building
Maintenance Cafeteria Inspection Shaping Assembly
Variable costs to be allocated . . . . . . . . . . . . . . . . $ 0 $ 94,000 $ 42,000
Cafeteria allocation:
$200 per employee ⫻ 30 employees . . . . . . (6,000) 6,000
$200 per employee ⫻ 190 employees . . . . . (38,000) $ 38,000
$200 per employee ⫻ 250 employees . . . . . (50,000) $ 50,000
Inspection allocation:
$0.06 per DLH ⫻ 300,000 DLH . . . . . . . . . . (18,000) 18,000
$0.06 per DLH ⫻ 500,000 DLH . . . . . . . . . . (30,000) 30,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 56,000 80,000
Fixed costs to be allocated . . . . . . . . . . . . . . . . . . 130,000 250,000 548,000
Building Maintenance allocation:*
$5 per square foot ⫻ 4,000 square feet . . . . (20,000) 20,000
$5 per square foot ⫻ 13,000 square feet . . . (65,000) 65,000
Cafeteria allocation:†
10% ⫻ $270,000 . . . . . . . . . . . . . . . . . . . . . . (27,000) 27,000
40% ⫻ $270,000 . . . . . . . . . . . . . . . . . . . . . . (108,000) 108,000
50% ⫻ $270,000 . . . . . . . . . . . . . . . . . . . . . . (135,000) 135,000
Inspection allocation:‡
70% ⫻ $580,000 . . . . . . . . . . . . . . . . . . . . . . (406,000) 406,000
30% ⫻ $580,000 . . . . . . . . . . . . . . . . . . . . . . (174,000) 174,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 554,000 374,000
Total allocated costs . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 0 $ 0 610,000 454,000
Other budgeted costs . . . . . . . . . . . . . . . . . . . . . . 1,340,000 1,846,000
Total budgeted overhead costs (a) . . . . . . . . . . . . $1,950,000 $2,300,000
Budgeted direct labor-hours (b) . . . . . . . . . . . . . . 300,000 500,000
Predetermined overhead rate, (a) ⫼ (b) . . . . . . . . $6.50 $4.60
* Square footage of space . . . . . . . . . . . . . . 29,000 square feet
Less Building Maintenance space . . . . . . . 3,000 square feet
Net space for allocation . . . . . . . . . . . . . . . 26,000 square feet
Building Maintenance fixed costs, $130,000

⫽ $5 per square foot
Net space for allocation, 26,000 square feet
† ‡
Cafeteria fixed costs . . . . . . . . . . . . . . . . . . $250,000 Inspection fixed costs . . . . . . . . . . . . . . . . . $548,000
Allocated from Building Maintenance . . . . . 20,000 Allocated from Building Maintenance . . . . . 5,000
Total cost to be allocated . . . . . . . . . . . . . . $270,000 Allocated from Cafeteria . . . . . . . . . . . . . . . 27,000
Total cost to be allocated . . . . . . . . . . . . . . $580,000
Allocation percentages are given.
Allocation percentages are given.
costs that would have been allocated to the two sales territories over the two-year span us-
ing actual miles driven as the allocation base are as follows:
Year 1:
Western sales territory: 1,500,000 miles at $0.04 per mile . . . . . . $ 60,000
Eastern sales territory: 1,500,000 miles at $0.04 per mile . . . . . . 60,000
Total cost allocated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000
Year 2:
Western sales territory: 1,500,000 miles at $0.05 per mile . . . . . . $ 75,000
Eastern sales territory: 900,000 miles at $0.05 per mile . . . . . . . . 45,000
Total cost allocated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000
In Year 1, the two sales territories share the service department costs equally. In Year
2, however, the bulk of the service department costs are allocated to the Western sales ter-
ritory. This is not because of any increase in activity in the Western sales territory; rather,
it is because of the decrease in activity in the Eastern sales territory. Even though the
Western sales territory maintained the same level of activity in both years, it is penalized
with a heavier cost allocation in Year 2 because of what has happened in another part of
the company.
This kind of inequity is almost inevitable when a variable allocation base is used to
allocate fixed costs. The manager of the Western sales territory undoubtedly will be upset
about the inequity forced on his territory, but he will feel powerless to do anything about
it. The result will be a loss of confidence in the system and considerable ill will.
FRUSTRATION IN THE PATHOLOGY LAB IN BUSINESS

Hospitals in New Zealand, as elsewhere, are under considerable pressure to reduce costs. Conse-
quently, managers are being held responsible for the costs of their departments and performance
evaluations are often heavily influenced by cost control efforts. How these costs are computed can
have a dramatic impact on evaluations. According to the accounting department of Waikato Hospi-
tal, the average cost per test in the hospital’s pathology lab had increased from NZ$5.90 to
NZ$7.29 over a three-year period. On the other hand, according to the management of the pathol-
ogy lab, the cost per test had decreased from NZ$1.44 to NZ$1.42 over the same period. (NZ$ de-
notes a New Zealand dollar.) What accounts for this huge discrepancy in both the cost per test and
the trend over time? The accounting department included allocations of the hospital’s general over-
head costs in the costs of the pathology lab; the managers of the pathology lab did not. The hospi-
tal’s accounting staff conceded that the pathology laboratory was indeed more efficient in terms of
its direct costs, but “Unfortunately, they’re getting more indirect costs [allocated to them].” The man-
ager of the pathology lab, who had taken aggressive steps to improve efficiency and control costs,
was outraged.
Source: Necia France, Graham Francis, Stewart Lawrence, and Sydney Sacks, “Cost Counting and Comparabil-
ity: Aspects of Performance Measurement in a Pathology Laboratory,” Pacific Accounting Review 14, no. 2,
December 2002, pp. 1–31.
Instructor’s Note
Beware of Sales Dollars as an Allocation Base Ask students to suppose they are a
division manager in a company that
Sales dollars is a popular allocation base for service department costs. One reason is that allocates fixed costs on the basis of
a sales dollars base is simple, straightforward, and easy to work with. Another reason is actual sales. Ask if the fixed costs
that people tend to view sales dollars as a measure of ability to pay, and, hence, as a mea- allocated to their division will
sure of how readily costs can be absorbed from other parts of the organization. depend on sales in other divisions. If
Unfortunately, sales dollars are often a very poor allocation base, for the reason that they say yes, ask if this is fair. There
sales dollars vary from period to period, whereas the costs being allocated are often will probably be a chorus of no’s.
largely fixed. As discussed earlier, if a variable allocation base is used to allocate fixed Ask how this differs from grading on
a curve. After some direction, they
costs, the costs allocated to one department will depend in large part on what happens in
should conclude that if you do better
other departments. A letup in sales effort in one department will shift allocated costs from
on an exam than others, your grade
that department to other, more successful departments. In effect, the departments putting will be higher and other students’
forth the best sales efforts are penalized in the form of higher allocations. The result is of- grades will be lower. However, if
ten bitterness and resentment on the part of the managers of the better departments. your sales increase relative to other
Consider the following situation encountered by one of the authors: divisions, the fixed costs allocated to
A large men’s clothing store has one service department and three sales depart- you will increase and that allocated
ments—Suits, Shoes, and Accessories. The service department’s costs total $60,000 per to other divisions will decrease.
period and are allocated to the three sales departments according to sales dollars. A recent
period showed the following allocation:
Departments
Suits Shoes Accessories Total
Sales by department . . . . . . . . . . . $260,000 $40,000 $100,000 $400,000
Percentage of total sales . . . . . . . 65% 10% 25% 100%
Allocation of service department
costs, based on percentage of
total sales . . . . . . . . . . . . . . . . . $39,000 $6,000 $15,000 $60,000
In the following period, the manager of the Suits Department launched a very suc-
cessful program to expand sales by $100,000 in his department. Sales in the other two de-
partments remained unchanged. Total service department costs also remained unchanged,
but the allocation of these costs changed substantially, as shown below:
Departments
Suits Shoes Accessories Total
Sales by department . . . . . . . . . . . $360,000 $40,000 $100,000 $500,000
Percentage of total sales . . . . . . . 72% 8% 20% 100%
Allocation of service department
costs, based on percentage of
total sales . . . . . . . . . . . . . . . . . $43,200 $4,800 $12,000 $60,000
Increase (or decrease) from
prior allocation . . . . . . . . . . . . . . $4,200 $(1,200) $(3,000) $0
The manager of the Suits Department complained that as a result of his successful ef-
fort to expand sales in his department, he was being forced to carry a larger share of the
service department costs. On the other hand, the managers of the departments that showed
no improvement in sales were relieved of a portion of the costs that they had been carry-
ing. Yet there had been no change in the amount of services provided for any department.
The manager of the Suits Department viewed the increased service department cost
allocation to his department as a penalty for his outstanding performance, and he won-
dered whether his efforts had really been worthwhile in the eyes of top management.
Sales dollars should be used as an allocation base only in those cases where service
department costs are driven by sales. In those situations where service department costs
are fixed, they should be allocated according to the three guidelines discussed earlier in
the chapter.
Summary Summary
Service departments are organized to provide some needed service in a single, centralized place,
rather than having all units within the organization provide the service for themselves. Service de-
partment costs are charged to operating departments by an allocation process. In turn, the operat-
ing departments include the allocated costs in their budgets, from which overhead rates are
computed for purposes of costing products or services.
Variable and fixed service department costs should be allocated separately. The variable costs
should be allocated according to whatever activity causes their incurrence. The fixed costs should
be allocated in predetermined lump-sum amounts according to either the peak-period or the long-
run average servicing needs of the consuming departments. Budgeted costs, rather than actual
costs, should always be allocated. If actual costs were allocated, the operating departments would
be implicitly held responsible for any inefficiency in the service departments. Any variances
between budgeted and actual service department costs should be kept within the service depart-
ments and should be the responsibility of the service department managers.
Review Problem: Direct and StepReview Problem: Direct and Step Methods
Methods
Kovac Printing Company has three service departments and two operating departments. Selected
data for the five departments relating to the most recent period follow:
Service Operating
Offset
Training Janitorial Maintenance Printing Lithography Total
Overhead costs . . . . . . . . . . . . . . . . . $360,000 $210,000 $96,000 $400,000 $534,000 $1,600,000

Number of employees . . . . . . . . . . . . 120 70 280 630 420 1,520
Square feet of space occupied . . . . . 10,000 20,000 40,000 80,000 200,000 350,000
Hours of press time . . . . . . . . . . . . . . — — — 30,000 60,000 90,000
The company allocates service department costs in the following order and using the bases indi-
cated: Training (number of employees), Janitorial (space occupied), and Maintenance (hours of
press time). Contrary to best practice, the company makes no distinction between variable and
fixed service department costs in its allocations.
Required:
1. Use the direct method to allocate service department costs to the operating departments.
2. Use the step method to allocate service department costs to the operating departments.
Solution to Review Problem

1. Under the direct method, service department costs are allocated directly to the operating de-
partments. Supporting computations for these allocations follow:
Allocation Bases
Training Janitorial Maintenance
Offset Printing data . . 630 employees 3/5 80,000 square feet 2/7 30,000 hours 1/3
Lithography data . . . . 420 employees 2/5 200,000 square feet 5/7 60,000 hours 2/3
Total . . . . . . . . . . . . . 1,050 employees 5/5 280,000 square feet 7/7 90,000 hours 3/3
Given these allocation rates, the allocations to the operating departments would be as follows:
Service Operating
Offset
Overhead costs . . . . . . . . . . . . . . . . . $360,000 $210,000 $ 96,000 $400,000 $534,000 $1,600,000
Allocation:
Training (3/5; 2/5) . . . . . . . . . . . . . (360,000) 216,000 144,000
Janitorial (2/7; 5/7) . . . . . . . . . . . . . (210,000) 60,000 150,000
Maintenance (1/3; 2/3) . . . . . . . . . . (96,000) 32,000 64,000
Total overhead cost
after allocations . . . . . . . . . . . . . . . $ 0 $ 0 $ 0 $708,000 $892,000 $1,600,000
2. Under the step method, services rendered between service departments are recognized when
costs are allocated to other departments. Starting with the Training service department, sup-
porting computations for these allocations follow:
Allocation Bases
Training Janitorial Maintenance
Janitorial data . . . . . 70 employees 5% — —
Maintenance data . . 280 employees 20% 40,000 square feet 1/8 —
Offset Printing data . 630 employees 45% 80,000 square feet 2/8 30,000 hours 1/3
Lithography data . . . 420 employees 30% 200,000 square feet 5/8 60,000 hours 2/3
Total . . . . . . . . . . . . 1,400 employees 100% 320,000 square feet 8/8 90,000 hours 3/3
Given these ratios, the allocations to the various departments would be as follows:
Service Operating
Offset
Overhead costs . . . . . . . . . . . . . . . . . $360,000 $210,000 $ 96,000 $400,000 $534,000 $1,600,000

Allocation:
Training (5%; 20%; 45%; 30%)* . . (360,000) 18,000 72,000 162,000 108,000
Janitorial (1/8; 2/8; 5/8) . . . . . . . . . (228,000) 28,500 57,000 142,500
Maintenance (1/3; 2/3) . . . . . . . . . . (196,500) 65,500 131,000
Total overhead cost after allocations . $ 0 $ 0 $ 0 $684,500 $915,500 $1,600,000
*Allocation rates can be shown either in percentages, in fractions, or as a dollar rate per unit of activity. Both percentages and fractions
are shown in this problem for sake of illustration. It is better to use fractions if the use of percentages would result in rounding errors.
Glossary Glossary
Direct method The allocation of a service department’s costs directly to operating departments
without recognizing services provided to other service departments. (p. 720)
Interdepartmental services Services provided between service departments. Also see Reciprocal
services. (p. 719)
Operating department A department or similar unit in an organization within which the central
purposes of the organization are carried out. (p. 718)
Reciprocal method A method of allocating service department costs that gives full recognition to
interdepartmental services. (p. 722)
Reciprocal services Services provided between service departments. Also see Interdepartmental
services. (p. 719)
Service department A department that provides support or assistance to operating departments
and that does not engage directly in production or in other operating activities of an organiza-
tion. (p. 718)
Step method The allocation of service department costs to other service departments, as well as
to operating departments, in a sequential manner. (p. 721)
Questions Questions
15–1 What is the difference between a service department and an operating department? Give
several examples of service departments.
15–2 How are service department costs assigned to products and services?
15–3 What are interdepartmental service costs? How are such costs allocated to other depart-
ments under the step method?
15–4 How are service department costs allocated to other departments under the direct method?
15–5 If a service department generates revenues, how do these revenues enter into the allocation
of the department’s costs to other departments?
15–6 What guidelines should govern the allocation of fixed service department costs to other de-
partments? The allocation of variable service department costs?
15–7 “A variable allocation base should never be used in allocating fixed service department
costs to operating departments.” Explain.
Exercises Exercises
EXERCISE 15–1 Direct Method [LO1]
Seattle Western University has provided the following data to be used in its service department cost
allocations:
Service Departments Operating Departments

Facility Undergraduate Graduate
Administration Services Programs Programs
Departmental costs before
allocations . . . . . . . . . . . . . . $2,400,000 $1,600,000 $26,800,000 $5,700,000
Student credit-hours . . . . . . . . 20,000 5,000
Space occupied—square feet . 25,000 10,000 70,000 30,000
Required:
Using the direct method, allocate the costs of the service departments to the two operating depart-
ments. Allocate administrative costs on the basis of student credit-hours and facility services costs
on the basis of space occupied.
EXERCISE 15–2 Step Method [LO2]

Madison Park Co-op, a whole foods grocery and gift shop, has provided the following data to be
used in its service department cost allocations:

Administration Janitorial Groceries Gifts
Departmental costs before allocations . . . $150,000 $40,000 $2,320,000 $950,000

Employee-hours . . . . . . . . . . . . . . . . . . . . 320 160 3,100 740
Space occupied—square feet . . . . . . . . . . 250 100 4,000 1,000
Required:
Using the step method, allocate the costs of the service departments to the two operating depart-
ments. Allocate administrative costs first on the basis of employee-hours and then janitorial costs
on the basis of space occupied.
EXERCISE 15–3 Allocations by Cost Behavior at the Beginning of the Period [LO3]
Hannibal Steel Company has a Transport Services Department that provides trucks to haul ore from
the company’s mine to its two steel mills—the Northern Plant and the Southern Plant. Budgeted
costs for the Transport Services Department total $350,000 per year, consisting of $0.25 per ton
variable cost and $300,000 fixed cost. The level of fixed cost is determined by peak-period re-
quirements. During the peak period, the Northern Plant requires 70% of the Transport Services De-
partment’s capacity and the Southern Plant requires 30%.
During the coming year, 120,000 tons of ore are budgeted to be hauled for the Northern Plant
and 60,000 tons of ore for the Southern Plant.
Required:
Compute the amount of Transport Services Department cost that should be allocated to each plant
at the beginning of the year for purposes of computing predetermined overhead rates. (The com-
pany allocates variable and fixed costs separately.)
EXERCISE 15–4 Allocations by Cost Behavior at the End of the Period [LO3]
Refer to the data in Exercise 15-3. Assume that it is now the end of the year. During the year,
the Transport Services Department actually hauled the following amounts of ore for the two plants:
Northern Plant, 130,000 tons; Southern Plant, 50,000 tons. The Transport Services Department
incurred $364,000 in cost during the year, of which $54,000 was variable cost and $310,000 was
fixed cost.
Management wants end-of-year service department cost allocations in order to compare actual
performance to planned performance.
Required:
1. Determine how much of the $54,000 in variable cost should be allocated to each plant.
2. Determine how much of the $310,000 in fixed cost should be allocated to each plant.
3. Should any of the $364,000 in the Transport Services Department cost not be allocated to the
plants? Explain.
EXERCISE 15–5 Step Method [LO2]

The Ferre Publishing Company has three service departments and two operating departments. Se-
lected data from a recent period on the five departments follow:

Administration Janitorial Maintenance Binding Printing Total
Overhead costs . . . . . . . . . . . . . . . . $140,000 $105,000 $48,000 $275,000 $430,000 $998,000

Number of employees . . . . . . . . . . . 60 35 140 315 210 760
Square feet of space occupied . . . . 15,000 10,000 20,000 40,000 100,000 185,000
Hours of press time . . . . . . . . . . . . . 30,000 60,000 90,000
The company allocates service department costs by the step method in the following order: Ad-
ministration (number of employees), Janitorial (space occupied), and Maintenance (hours of press
time). The company makes no distinction between variable and fixed service department costs.
Required:
Using the step method, allocate the service department costs to the operating departments.
EXERCISE 15–6 Direct Method [LO1]

Refer to the data for the Ferre Publishing Company in Exercise 15–5.
Required:
Assuming that the company uses the direct method rather than the step method to allocate service
department costs, how much overhead cost would be assigned to each operating department?
EXERCISE 15–7 Sales Dollars as an Allocation Base for Fixed Costs [LO3]
Konig Enterprises, Ltd., owns and operates three restaurants in Vancouver, B.C. The company allo-
cates its fixed administrative expenses to the three restaurants on the basis of sales dollars. During
2004, the fixed administrative expenses totaled $2,000,000. These expenses were allocated as follows:
Restaurants
Rick’s Imperial Ginger
Harborside Garden Wok Total
Total sales—2004 . . . . . . $16,000,000 $15,000,000 $9,000,000 $40,000,000

Percentage of total sales . 40% 37.5% 22.5% 100%
Allocation (based on the
above percentages) . . . $800,000 $750,000 $450,000 $2,000,000
During 2005, the following year, the Imperial Garden restaurant increased its sales by $10 million.
The sales levels in the other two restaurants remained unchanged. The company’s 2005 sales data
were as follows:
Restaurants
Rick’s Imperial Ginger
Harborside Garden Wok Total
Total sales—2005 . . . . . . $16,000,000 $25,000,000 $9,000,000 $50,000,000

Percentage of total sales . 32% 50% 18% 100%
Fixed administrative expenses remained unchanged at $2,000,000 during 2005.

Required:
1. Using sales dollars as an allocation base, show the allocation of the fixed administrative ex-
penses among the three restaurants for 2005.
2. Compare your allocation from (1) above to the allocation for 2004. As the manager of the Im-
perial Garden, how would you feel about the allocation that has been charged to you for 2005?
3. Comment on the usefulness of sales dollars as an allocation base.
EXERCISE 15–8 Allocating Variable Costs at the End of the Year [LO3]
Westlake Hospital has a Radiology Department that provides X-ray services to the hospital’s three
operating departments. The variable costs of the Radiology Department are allocated to the oper-
ating departments on the basis of the number of X-rays provided for each department. Budgeted
and actual data relating to the cost of X-rays taken last year are given below:
Variable Costs
Budgeted Actual
Radiology Department . . . . . . . . $18 per X-ray $20 per X-ray
The budgeted and actual number of X-rays provided for each operating department last year follow:
OB General
Pediatrics Care Hospital
Budgeted number of X-rays . . . . 7,000 4,500 12,000
Actual number of X-rays taken . . 6,000 3,000 15,000
Required:
Determine the amount of Radiology Department variable cost that should have been allocated to
each of the three operating departments at the end of last year for purposes of comparing actual per-
formance to planned performance.
EXERCISE 15–9 Allocations of Fixed Costs [LO3]

Refer to Westlake Hospital in Exercise 15–8. In addition to the Radiology Department, the hospi-
tal also has a Janitorial Services Department that provides services to all other departments in the
hospital. The fixed costs of the two service departments are allocated using the following bases:
Department Basis for Allocation
Janitorial Services . . . . . . Square feet of space occupied:

Radiology Department . . . . . . . . . . . . . . 6,000 square feet
Pediatrics . . . . . . . . . . . . . . . . . . . . . . . . 30,000 square feet
OB Care . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 square feet
General Hospital . . . . . . . . . . . . . . . . . . . 90,000 square feet
Radiology . . . . . . . . . . . . . Long-run average X-ray needs per year:
Pediatrics . . . . . . . . . . . . . . . . . . . . . . . . 9,000 X-rays
OB Care . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 X-rays
General Hospital . . . . . . . . . . . . . . . . . . . 15,000 X-rays
Budgeted and actual fixed costs in the two service departments for the year follow:
Janitorial
Services Radiology
Budgeted fixed costs . . . . . . . . . $375,000 $590,000

Actual fixed costs . . . . . . . . . . . . $381,000 $600,000
Required:
1. Show the allocation of the fixed costs of the two service departments at the beginning of the
year. The hospital uses the step method of allocation.
2. Show the allocation of the fixed costs of the two service departments at the end of the year for
purposes of comparing actual performance to planned performance.
Problems Problems
PROBLEM 15–10 Step Method versus Direct Method; Predetermined Overhead Rates [LO1, LO2]
Check Figure The Sendai Co., Ltd., of Japan has budgeted costs in its various departments as follows for the
(2) Machining rate: ¥7,834 per hour coming year:
Factory Administration . . . . . . . . . ¥270,000,000

Custodial Services . . . . . . . . . . . . 68,760,000
Personnel . . . . . . . . . . . . . . . . . . 28,840,000
Maintenance . . . . . . . . . . . . . . . . 45,200,000
Machining—overhead . . . . . . . . . 376,300,000
Assembly—overhead . . . . . . . . . 175,900,000
Total cost . . . . . . . . . . . . . . . . . . . ¥965,000,000
The Japanese currency is the yen, denoted by ¥. The company allocates service department
costs to other departments in the order listed below.
Square
Total Feet of Direct
Number of Labor- Space Labor- Machine-
Department Employees Hours Occupied Hours hours
Factory Administration . . . . 12 — 5,000 — —
Custodial Services . . . . . . . 4 3,000 2,000 — —
Personnel . . . . . . . . . . . . . . 5 5,000 3,000 — —
Maintenance . . . . . . . . . . . . 25 22,000 10,000 — —
Machining . . . . . . . . . . . . . . 40 30,000 70,000 20,000 70,000
Assembly . . . . . . . . . . . . . . 60 90,000 20,000 80,000 10,000
146 150,000 110,000 100,000 80,000
Machining and Assembly are operating departments; the other departments are service depart-
ments. The company does not make a distinction between fixed and variable service department
costs. Factory Administration is allocated on the basis of labor-hours; Custodial Services on the ba-
sis of square feet occupied; Personnel on the basis of number of employees; and Maintenance on
the basis of machine-hours.
Required:
1. Allocate service department costs to consuming departments by the step method. Then com-
pute predetermined overhead rates in the operating departments using a machine-hours basis
in Machining and a direct labor-hours basis in Assembly.
2. Repeat (1) above, this time using the direct method. Again compute predetermined overhead
rates in Machining and Assembly.
3. Assume that the company doesn’t bother with allocating service department costs but simply
computes a single plantwide overhead rate based on total overhead costs (both service depart-
ment and operating department costs) divided by total direct labor-hours. Compute the
plantwide overhead rate.
4. Suppose a job requires machine and labor time as follows:
Machine- Direct
hours Labor-Hours
Machining Department . . . . . . . . 190 25
Assembly Department . . . . . . . . . 10 75
Total hours . . . . . . . . . . . . . . . . . . 200 100
Using the overhead rates computed in (1), (2), and (3) above, compute the amount of overhead
cost that would be assigned to the job if the overhead rates were developed using the step
method, the direct method, and the plantwide method.
PROBLEM 15–11 Allocating by Cost Behavior [LO3]

Sharp Motor Company has two operating divisions—an Auto Division and a Truck Division. The
company has a cafeteria that serves the employees of both divisions. The costs of operating the
cafeteria are budgeted at $40,000 per month plus $3 per meal served. The company pays all
x
e cel
the cost of the meals. Check Figure
The fixed costs of the cafeteria are determined by peak-period requirements. The Auto Divi- (1) Cost to Auto Division: $131,000
sion is responsible for 65% of the peak-period requirements, and the Truck Division is responsible
for the other 35%.
For June, the Auto Division has estimated that it will need 35,000 meals served, and the Truck
Division has estimated that it will need 20,000 meals served.
Required:
1. At the beginning of June, how much cafeteria cost should be allocated to each division for
planning purposes?
2. Assume that it is now the end of June. Cost records in the cafeteria show that actual fixed costs
for the month totaled $42,000 and that actual meal costs totaled $128,000. Due to unexpected
layoffs of employees during the month, only 20,000 meals were served to the Auto Division.
Another 20,000 meals were served to the Truck Division, as planned. How much of the actual
cafeteria costs for the month should be allocated to each division? (Management uses these
end-of-month allocations to compare actual performance with planned performance.)
3. Refer to the data in (2) above. Assume that the company follows the practice of allocating all
cafeteria costs to the divisions in proportion to the number of meals served to each division
during the month. On this basis, how much cost would be allocated to each division for June?
4. What criticisms can you make of the allocation method used in (3) above?
5. If managers of operating departments know that fixed service costs are going to be allocated
on the basis of peak-period requirements, what will be their probable strategy as they report
their estimate of peak-period requirements to the company’s budget committee? As a member
of top management, what would you do to neutralize such strategies?
PROBLEM 15–12 Allocating Costs Equitably Among Divisions [LO3]

“These allocations don’t make any sense at all,” said Bob Cosic, manager of National Airlines’
Freight Division. “We used the maintenance hangar less during the second quarter than we did dur-
ing the first quarter, yet we were allocated more cost. Is that fair? In fact, we picked up the lion’s
Check Figure
share of the hangar’s cost during the second quarter, even though we’re a lot smaller than the Do-
(2) $160,000 fixed plus $4 per hour
mestic Passenger Division.”
National Airlines established the maintenance hangar to service its three operating divisions.
The company allocates the cost of the hangar to the divisions on the basis of the number of hours
of use each quarter. Allocations for the first two quarters to which Mr. Cosic was referring are given
below:
“Now don’t get upset, Bob,” replied Colleen Rogers, the controller. “Those allocations are
fair. As you can see, your division used the hangar more than any other division during the second
quarter and therefore it has been allocated the largest share of cost. Although use of the hangar was
off somewhat during the second quarter, keep in mind that most of the hangar’s costs are fixed and
therefore continue regardless of how much the hangar is used. Also, remember that we built enough
capacity into the hangar to handle the divisions’ peak-period needs, and that cost has to be absorbed
by someone. The fairest way to handle it is to charge according to usage from quarter to quarter.
When you use the hangar more, you get charged more; it’s as simple as that.”
“That’s just the point,” replied Cosic. “I didn’t use the hangar more, I used it less. So why am
I charged more?”
The Freight Division requires 30% of the hangar’s capacity during peak periods; the Domes-
tic Passenger Division, 50%; and the Overseas Passenger Division, 20%. The peak period occurs
in the fourth quarter of the year.
Required:
1. Is there any merit to Mr. Cosic’s complaint? Explain.
2. Using the high-low method, determine the cost formula for the hangar in terms of a variable
rate per hour and total fixed cost each quarter.
3. Reallocate the hangar costs for the first and second quarters in accordance with the cost allo-
cation principles discussed in the chapter. Allocate the variable and fixed costs separately.
PROBLEM 15–13 Step Method [LO2, LO3]
Check Figure
x
e cel Woodbury Hospital has three service departments and three operating departments. Estimated cost
and operating data for all departments in the hospital for the forthcoming quarter are presented in
the table below:
Cost to laboratory: $497,560

Housekeeping Food Admin. General
Services Services Services Laboratory Radiology Hospital Total
Variable costs . . . . . . . . . . . . . . . . $ 0 $193,860 $158,840 $243,600 $304,800 $ 74,500 $ 975,600

Fixed costs . . . . . . . . . . . . . . . . . . 87,000 107,200 90,180 162,300 215,700 401,300 1,063,680
Total cost . . . . . . . . . . . . . . . . . . . . $87,000 $301,060 $249,020 $405,900 $520,500 $475,800 $2,039,280
Meals served . . . . . . . . . . . . . . . . 800 2,000 1,000 68,000 71,800

Percentage of peak-period
needs—Food Services . . . . . . . 0.8% 2.4% 1.6% 95.2% 100%
Square feet of space . . . . . . . . . . . 5,000 13,000 6,500 10,000 7,500 108,000 150,000
Files processed . . . . . . . . . . . . . . . 14,000 7,000 25,000 46,000
needs—Admin. Services . . . . . . 30% 20% 50% 100%
The costs of the service departments are allocated by the step method using the allocation bases and
in the order shown in the following table:
Costs
Service Department Incurred Allocation Bases
Housekeeping Services . . . . . . . . . . Fixed Square feet of space

Food Services . . . . . . . . . . . . . . . . . . Variable Meals served
Fixed Peak-period needs—Food Services
Administrative Services . . . . . . . . . . . Variable Files processed
Fixed Peak-period needs—Admin. Services
All billing in the hospital is done through Laboratory, Radiology, or General Hospital. The hospi-
tal’s administrator wants the costs of the three service departments allocated to these three billing
centers.
Required:
Prepare the cost allocation desired by the hospital administrator. (Use the step method.) Include un-
der each billing center the direct costs of the center, as well as the costs allocated from the service
departments.
PROBLEM 15–14 Beginning- and End-of-Year Allocations [LO3]

Tasman Products, Ltd., of Australia has a Maintenance Department that services the equipment in
the company’s Forming Department and Assembly Department. The cost of this servicing is allo-
cated to the operating departments on the basis of machine-hours. Cost and other data relating to
the Maintenance Department and to the other two departments for the most recent year are pre- Check Figure
sented below. (The currency in Australia is the Australian dollar.) (2a) Cost to Forming Department:
Data for the Maintenance Department follow: $181,000
Budget Actual
Variable costs for lubricants . . . . . . . . . . . $96,000* $110,000

Fixed costs for salaries and other . . . . . . $150,000 $153,000
*Budgeted at $0.40 per machine-hour.
Data for the Forming and Assembly departments follow:
Percentage of Machine-Hours
Peak-Period
Capacity Required Budget Actual
Forming Department . . . . . . . . . 70% 160,000 190,000
Assembly Department . . . . . . . . 30% 80,000 70,000
Total . . . . . . . . . . . . . . . . . . . . . . 100% 240,000 260,000
The company allocates variable and fixed costs separately. The level of fixed costs in the
Maintenance Department is determined by peak-period requirements.
Required:
1. Assume that it is the beginning of the year. How much of the budgeted Maintenance Depart-
ment cost would be allocated to each department?
2. Assume that it is now the end of the year. Management would like data to assist in comparing
actual performance to planned performance in the Maintenance Department and in the other
departments.
a. How much of the actual Maintenance Department costs should be allocated to the Form-
ing Department and to the Assembly Department? Show all computations.
b. Should any portion of the actual Maintenance Department costs not be allocated to the
other departments? If all costs should be allocated, explain why; if a portion should not
be allocated, compute the amount and explain why it should not be allocated.
PROBLEM 15–15 Step Method; Predetermined Overhead Rates [LO2, LO3] Check Figure
Bombay Castings, Ltd., has two operating departments, Fabrication and Finishing, and three ser- (2) Fabrication Department rate:
vice departments. The service departments and the bases on which their costs are allocated to con- R9.33 per hour
suming departments are listed below:
Department Cost Allocation Bases

Building and Grounds . . . . . . . . . . . . Fixed Square feet occupied
Administration . . . . . . . . . . . . . . . . . . Variable Number of employees
Fixed Employees at full capacity
Equipment Maintenance . . . . . . . . . . Variable Machine-hours
Fixed 40% to Fabrication
60% to Finishing
Indian currency is denominated in rupees, denoted here by R.

Service department costs are allocated to consuming departments by the step method in the or-
der shown. The company has developed the cost and operating data given in the following table for
purposes of preparing overhead rates in the two operating departments:
Building
and Adminis- Equipment
Grounds tration Maintenance Fabrication Finishing Total
Variable costs . . . . . . . . . . . . . . . . . . . . . R 0 R22,200 R16,900 R146,000 R320,000 R 505,100

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . 88,200 60,000 24,000 420,000 490,000 1,082,200
Total cost . . . . . . . . . . . . . . . . . . . . . . . . R88,200 R82,200 R40,900 R566,000 R810,000 R1,587,300
Budgeted employees . . . . . . . . . . . . . . . 6 4 30 450 630 1,120

Employees at full capacity . . . . . . . . . . . 8 4 45 570 885 1,512
Square feet occupied . . . . . . . . . . . . . . . 600 500 1,400 12,000 15,500 30,000
Budgeted machine-hours . . . . . . . . . . . . 70,000 105,000 175,000
Required:
1. Show the allocation of service department costs to operating departments for purposes of
preparing overhead rates in Fabrication and Finishing.
2. Assuming that overhead rates are calculated using machine-hours as the allocation base, com-
pute the overhead rate for each operating department.
3. Assume the following actual data for the year for the Administration Department:
Actual variable costs . . . . . . . . . . . . . . R23,800

Actual employees for the year:
Building and Grounds . . . . . . . . . . . . 6
Administration . . . . . . . . . . . . . . . . . 4
Equipment Maintenance . . . . . . . . . 32
Fabrication . . . . . . . . . . . . . . . . . . . . 460
Finishing . . . . . . . . . . . . . . . . . . . . . . 625
1,127
Compute the amount of end-of-year Administration Department variable cost that should be
allocated to each department. (Management uses these end-of-year allocations to compare ac-
tual performance to planned performance.)
PROBLEM 15–16 Step Method [LO2, LO3]

The Bayview Resort has three operating units—the Convention Center, Food Services, and Guest
Lodging. These three operating units are supported by three service units—General Administration,
Cost Accounting, and Laundry. The costs of the service units are allocated by the step method us-
Check Figure ing the allocation bases and in the order shown below:
Cost to Food Services: $513,980
General Administration:
Fixed costs—allocated 10% to Cost Accounting, 4% to the
Laundry, 30% to the Convention Center, 16% to Food
Services, and 40% to Guest Lodging.
Cost Accounting:
Variable costs—allocated on the basis of the number of items
processed each period.
Fixed costs—allocated on the basis of peak-period
requirements.
Laundry:
Variable costs—allocated on the basis of the number of
pounds of laundry processed each period.
Fixed costs—allocated on the basis of peak-period
requirements.
Cost and operating data for all units in the resort for a recent quarter are given in the follow-
ing table:
Service Units Operating Units

General Cost Convention Food Guest
Administration Accounting Laundry Center Services Lodging Total
Variable costs . . . . . . . . . . . . . . . . . . . . $ 0 $ 70,000 $143,000 $ 0 $ 52,000 $ 24,000 $ 289,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . 200,000 110,000 65,900 95,000 375,000 486,000 1,331,900
Total overhead cost . . . . . . . . . . . . . . . $200,000 $180,000 $208,900 $95,000 $427,000 $510,000 $1,620,900
Pounds of laundry processed . . . . . . . . 20,000 15,000 210,000 245,000

requirements—Laundry . . . . . . . . . . 10% 6% 84% 100%
Number of items processed . . . . . . . . . 1,000 800 1,200 3,000 9,000 15,000
requirements—Cost Accounting . . . . * 7% 13% 20% 60% 100%
*General administration is excluded from the computation of peak-period requirements due to the order in which the service unit costs
are allocated.
Since all billing is done through the Convention Center, Food Services, and Guest Lodging,
the resort’s general manager wants the costs of the three service units allocated to these three billing
centers.
Required:
Prepare the cost allocation desired by the resort’s general manager. Include under each billing cen-
ter the direct costs of the center, as well as the costs allocated from the service units.
Cases Cases
CASE 15–17 Direct Method; Plantwide versus Departmental Overhead Rates [LO1, LO3]
Hobart Products manufactures a complete line of fiberglass attaché cases and suitcases. Hobart has
three manufacturing (or operating) departments—Molding, Component, and Assembly—and two
service departments—Power and Maintenance.
The sides of the cases are manufactured in the Molding Department. The frames, hinges, Check Figure
locks, and so forth, are manufactured in the Component Department. The cases are completed in (1) Overhead rate: $20.55 per DLH
the Assembly Department. Varying amounts of materials, time, and effort are required for each of
the various cases. The Power Department and Maintenance Department provide services to the
manufacturing departments.
Hobart has always used a plantwide overhead rate. Direct labor-hours are used to assign the
overhead to products. The overhead rate is computed by dividing the company’s total estimated
overhead cost by the total estimated direct labor-hours to be worked in the three manufacturing
departments.
Whit Portlock, manager of Cost Accounting, has recommended that the company use depart-
mental overhead rates rather than a single, plantwide rate. Planned operating costs and expected lev-
els of activity for the coming year have been developed by Mr. Portlock and are presented below:
Service Departments
Power Maintenance
Departmental activity measures:

Estimated usage in the coming year . . . . . . . 80,000 KWh 12,500 hours*
Departmental costs:
Materials and supplies . . . . . . . . . . . . . . . . . $ 500,000 $ 25,000
Variable labor . . . . . . . . . . . . . . . . . . . . . . . . 140,000 0
Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . 1,200,000 375,000
Total service department cost . . . . . . . . . . . . $1,840,000 $400,000
*Hours of maintenance time.

Manufacturing Departments
Molding Component Assembly
Departmental activity measures:
Direct labor-hours . . . . . . . . . . 50,000 200,000 150,000
Machine-hours . . . . . . . . . . . . 87,500 12,500 0
Departmental costs:
Raw materials . . . . . . . . . . . . . $1,630,000 $3,000,000 $ 25,000
Direct labor . . . . . . . . . . . . . . . 350,000 2,000,000 1,300,000
Variable overhead . . . . . . . . . . 210,500 1,000,000 1,650,000
Fixed overhead . . . . . . . . . . . . 1,750,000 620,000 749,500
Total departmental cost . . . . . $3,940,500 $6,620,000 $3,724,500
Manufacturing Departments
Molding Component Assembly
Use of service departments:

Maintenance:
Estimated usage in hours of
maintenance time for the
coming year . . . . . . . . . . 9,000 2,500 1,000
Maintenance Department
capacity required . . . . . . 70% 20% 10%
Power:
Estimated usage in
kilowatt-hours for the
coming year . . . . . . . . . . 36,000 32,000 12,000
Power Department
capacity required . . . . . . 50% 35% 15%
Required:
1. If the company uses a single, plantwide overhead rate for the coming year, what plantwide
overhead rate would be used?
2. Assume that Whit Portlock has been asked to develop departmental overhead rates for the
three manufacturing departments for comparison with the plantwide rate. In order to develop
these rates, do the following:
a. Using the direct method, allocate the service department costs to the manufacturing de-
partments. In each case, allocate the variable and fixed costs separately.
b. Compute overhead rates for the three manufacturing departments for the coming year. In
computing the rates, use machine-hours as the allocation base in the Molding Department
and direct labor-hours as the allocation base in the other two departments.
3. Assume that Hobart Products has one small attaché case that has the following annual re-
quirements for machine time and direct labor time in the various departments:
Machine- Direct
hours Labor-Hours
Molding Department . . . . . . . . . . 3,000 1,000
Component Department . . . . . . . 800 2,500
Assembly Department . . . . . . . . . 0 4,000
Total hours . . . . . . . . . . . . . . . . . . 3,800 7,500
a. Compute the amount of overhead cost that would be allocated to this attaché case if a
plantwide overhead rate is used. Repeat the computation, assuming that departmental
overhead rates are used.
b. Hobart Products bases its selling prices on its computed costs—adding a percentage
markup. Management is concerned because this attaché case is priced well below com-
peting products of competitors. On the other hand, Hobart has other products that are
priced well above its competitors, resulting in lost sales and declining profits. Looking at
the computations in (a), what effect is a plantwide rate having on the costing of products
and therefore on selling prices?
4. What additional steps could Hobart Products take to improve its overhead costing?
(CMA, adapted)
CASE 15–18 Step Method versus Direct Method [LO1, LO2]

“This is really an odd situation,” said Jim Carter, general manager of Highland Publishing Com-
pany. “We get most of the jobs we bid on that require a lot of press time in the Printing Department,
yet profits on those jobs are never as high as they ought to be. On the other hand, we lose most of
x
e cel
Check Figure
the jobs we bid on that require a lot of time in the Binding Department. I would be inclined to think
(1) Printing rate: $6.12 per hour
that the problem is with our overhead rates, but we’re already computing separate overhead rates
for each department. So what else could be wrong?”
Highland Publishing Company is a large organization that offers a variety of printing and
binding work. The Printing and Binding departments are supported by three service departments.
The costs of these service departments are allocated to other departments in the order listed below.
(For each service department, use the allocation base that provides the best measure of service pro-
vided, as discussed in the chapter.)
Total Square Feet Number Direct

Labor- of Space of Machine- Labor-
Department Hours Occupied Employees Hours Hours
Personnel . . . . . . . . . 20,000 4,000 10
Custodial Services . . . 30,000 6,000 15
Maintenance . . . . . . . 50,000 20,000 25
Printing . . . . . . . . . . . 90,000 80,000 40 150,000 60,000
Binding . . . . . . . . . . . . 260,000 40,000 120 30,000 175,000
450,000 150,000 210 180,000 235,000
Budgeted overhead costs in each department for the current year are shown below (no dis-
tinction is made between variable and fixed costs):
Personnel . . . . . . . . . . . . . . . $ 360,000
Custodial Services . . . . . . . . . 141,000
Maintenance . . . . . . . . . . . . . 201,000
Printing . . . . . . . . . . . . . . . . . 525,000
Binding . . . . . . . . . . . . . . . . . 373,500
Total budgeted cost . . . . . . . . $1,600,500
Because of its simplicity, the company has always used the direct method to allocate service
department costs to the two operating departments.
Required:
1. Using the step method, allocate the service department costs to the consuming departments.
Then compute predetermined overhead rates for the current year using machine-hours as the
allocation base in the Printing Department and direct labor-hours as the allocation base in the
Binding Department.
2. Repeat (1) above, this time using the direct method. Again compute predetermined overhead
rates in the Printing and Binding departments.
3. Assume that during the current year the company bids on a job that requires machine and la-
bor time as follows:
Machine- Direct
hours Labor-Hours
Printing Department . . . . . . . . . . 15,400 900
Binding Department . . . . . . . . . . 800 2,000
Total hours . . . . . . . . . . . . . . . . . 16,200 2,900
a. Determine the amount of overhead cost that would be assigned to the job if the company
used the overhead rates developed in (1) above. Then determine the amount of overhead
cost that would be assigned to the job if the company used the overhead rates developed
in (2) above.
b. Explain to Mr. Carter, the general manager, why the step method provides a better basis
for computing predetermined overhead rates than the direct method.
Group and Internet Exercises

Group and Internet Exercises
GROUP EXERCISE 15–19 Understanding the Cost of Complexity
Service departments (or production support departments in the case of a manufacturer) make up a
large and growing part of the cost structure of most businesses. This is as true in hospitals, finan-
cial institutions, universities, and other service industries as it is in manufacturing where produc-
tion support department costs can average 40% or more of total manufacturing costs.
In an effort to reduce costs, many companies seek to reduce head count, which is a demoral-
izing experience not only for those who lose their jobs, but also for those who remain employed.
One sure sign of problems with this head-count-reduction approach is that more than half of com-
panies refill these positions within a year after eliminating them.
Required:
1. Choose an industry with which you are somewhat familiar (or with which someone you know
is familiar) and list seven or eight major production support or service departments in the fac-
tory or other facility in this industry. What is the output of each of these support or service de-
partments?
2. Assume a relatively uncomplicated factory (facility) where just a single, standard product (or
service) is mass produced. Describe the activity or work being done in each of the service ar-
eas of this focused company.
3. Now assume a more complicated operation for another factory located close by where a wide
range of products are made or services are offered—some are standard products/services while
others are made to order, some are high-volume products/services while others are low vol-
ume, and some are fairly complex products/services while others are relatively simple. De-
scribe the activity or work being done in the various service functions for this full-service
company.
4. Which factory or facility has higher production support costs? Why?
5. Explain the relationship between the range of products produced and the size of the support
departments. When does the output of each of these support departments increase? When does
the cost of each of these support departments increase?
6. Most companies are under increasing pressure to reduce costs. How would you go about
bringing the overall level of service department costs down?
INTERNET EXERCISE 15–20

As you know, the World Wide Web is a medium that is constantly evolving. Sites come and go, and
change without notice. To enable periodic updating of site addresses, this problem has been posted
to the textbook website (www.mhhe.com/garrison11e). After accessing the site, enter the Student
Center and select this chapter. Select and complete the Internet Exercise.

Chap 15

Transféré par

Informations du document

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Chap 15

Transféré par

Droits d'auteur :

Formats disponibles

Garrison−Noreen−Brewer: 15.

Service Department Text © The McGraw−Hill

After studying Chapter 15, you should be able to:

LO1 Allocate service department costs to other departments, using the

LO2 Allocate service department costs to other departments, using the

LO3 Allocate variable and fixed service department costs separately at

What Difference Does It Make?

718 Chapter 15 Service Department Costing: An Activity Approach

ost large organizations have both operating departments and ser-

Chapter 15 Service Department Costing: An Activity Approach 719

INCREASING ACCURACY AT HUGHES AIRCRAFT IN BUSINESS

720 Chapter 15 Service Department Costing: An Activity Approach

Chapter 15 Service Department Costing: An Activity Approach 721

Custodial Services costs (5⁄ 50, 45 ⁄ 50)† . . . . . . . . (90,000) 9,000 81,000

Total costs after allocation . . . . . . . . . . . . . . . . . . $ 0 $ 0 $405,000 $995,000 $1,400,000

722 Chapter 15 Service Department Costing: An Activity Approach

Costs are allocated to

Departmental costs before allocation . . . . . . . . . $360,000 $ 90,000 $261,000 $ 689,000 $1,400,000

Total costs after allocation . . . . . . . . . . . . . . . . . . $ 0 $ 0 $394,000 $1,006,000 $1,400,000

IN BUSINESS STEPPING DOWN AT GROUP HEALTH

Reciprocal Method The reciprocal method gives full recognition to interdepart-

Chapter 15 Service Department Costing: An Activity Approach 723

Allocating Costs by Behavior Allocating Costs by Behavior

724 Chapter 15 Service Department Costing: An Activity Approach

Chapter 15 Service Department Costing: An Activity Approach 725

A Summary of Cost Allocation Guidelines

Implementing the Allocation Guidelines

Total . . . . . . . . . . . . . . . . . . . . . . . 100% 24,000

726 Chapter 15 Service Department Costing: An Activity Approach

Chapter 15 Service Department Costing: An Activity Approach 727

*$10 per flight-hour ⫻ 25,000 actual flight-hours ⫽ $250,000.

First Stage Second Stage EXHIBIT 15–5

728 Chapter 15 Service Department Costing: An Activity Approach

An Extended Example An Extended Example

Department Type of Cost Allocation Bases

Department Variable Cost Fixed Cost

Chapter 15 Service Department Costing: An Activity Approach 729

Some Cautions in Allocating ServiceinDepartment

730 Chapter 15 Service Department Costing: An Activity Approach

THE PROCTOR COMPANY

Building Maintenance fixed costs, $130,000

Chapter 15 Service Department Costing: An Activity Approach 731

FRUSTRATION IN THE PATHOLOGY LAB IN BUSINESS

732 Chapter 15 Service Department Costing: An Activity Approach

Chapter 15 Service Department Costing: An Activity Approach 733

Overhead costs . . . . . . . . . . . . . . . . . $360,000 $210,000 $96,000 $400,000 $534,000 $1,600,000

Solution to Review Problem

Overhead costs . . . . . . . . . . . . . . . . . $360,000 $210,000 $ 96,000 $400,000 $534,000 $1,600,000

734 Chapter 15 Service Department Costing: An Activity Approach

Overhead costs . . . . . . . . . . . . . . . . . $360,000 $210,000 $ 96,000 $400,000 $534,000 $1,600,000

Chapter 15 Service Department Costing: An Activity Approach 735

Service Departments Operating Departments

EXERCISE 15–2 Step Method [LO2]

Service Departments Operating Departments

Departmental costs before allocations . . . $150,000 $40,000 $2,320,000 $950,000

736 Chapter 15 Service Department Costing: An Activity Approach

EXERCISE 15–5 Step Method [LO2]

Service Departments Operating Departments

Overhead costs . . . . . . . . . . . . . . . . $140,000 $105,000 $48,000 $275,000 $430,000 $998,000

EXERCISE 15–6 Direct Method [LO1]

Total sales—2004 . . . . . . $16,000,000 $15,000,000 $9,000,000 $40,000,000

Total sales—2005 . . . . . . $16,000,000 $25,000,000 $9,000,000 $50,000,000

Fixed administrative expenses remained unchanged at $2,000,000 during 2005.