Class Session 5 (April 17, 2018)

Coverage: Chapter 15

Session Objectives: Allocation of indirect costs is an area of constant discussion in many companies,
with division, department, and product managers often questioning the amount of indirect costs
allocated to their respective sections. We will discuss alternative ways of allocating service
department costs and understand how divisional incentives are affected by the allocation choice. We
will also examine how to allocate common costs and bundled product revenue.

• Service departments (e.g., human resources (HR), information system (IT), materials handling,
repairs and maintenance, janitorial, security, cafeteria, etc.) are treated as cost centers.

To ensure that the costs of these departments are not ignored when computing product cost,

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service costs are allocated to the production departments, as an intermediate step in bringing all

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costs down to the products.

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Hence, for a production department, the total overhead includes
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(1) Allocated costs of service departments and common costs
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(2) Indirect costs incurred within the manufacturing departments

Typical Procedures for Product Costing:

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After directly tracing costs to the various service and production departments, most (traditional)
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product costing system uses a two-stage allocation scheme:

Stage I: allocate common costs and service department costs to the production department;
Stage II: allocate overhead of the production departments to products.
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Overhead Costs
Product Costs
Direct Costs
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 • In allocating service department costs to the operating department, a predetermined rate (i.e.,
a budgeted rate) is normally utilized to make the allocations to the operating departments.

What are the advantages of using a predetermined (budgeted) rate relative to actual rate?

The single-rate method makes no distinction between fixed and variable costs. It allocates
costs in each cost pool to cost objects using the same rate per unit of a single allocation base.

The dual-rate method divides the costs of each support department into two pools—a
variable-cost pool and a fixed-cost pool.

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In-class Exercise 1: Bio Labs

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Bio Labs is a genetic engineering firm manufacturing a variety of gene-spliced, agricultural-based
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seed products. The firm has five separate laboratories producing different product lines. Each lab is
treated as a profit center and all five labs are located in the same facility. The wheat seed lab and
corn seed lab manufacture two of the five product lines. These two labs are located next to each
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other and are of roughly equal size in terms of sales. The two departments have close interaction,
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often sharing equipment and lab technicians. Both use very similar technology and science and
usually attend the same scientific meetings.

Recent discoveries have shown how low-power lasers can be used to significantly improve product
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quality. The wheat seed and corn seed managers are proposing the creation of a laser testing
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department to employ this new technology. Leasing the equipment and hiring the personnel are
budgeted to cost $350,000 per year. Supplies, power, and other variable costs are expected to be $25
per testing hour. The testing department is expected to provide 2,000 testing hours per year. Wheat
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seed expects to use 700 testing hours per year of the laser testing department and corn seed expects
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to use 800 testing hours. The remaining 500 hours of testing capacity can be used by the other three
labs if the technology applies or can be left idle for future expected growth of the two departments.
Initially, only wheat and corn are expected to use laser testing.

The executive committee of Bio Labs has approved the proposal but is now grappling with how to
treat the costs of the laser testing department. The committee wants to charge the costs to wheat seed
and corn seed but is unsure of how to proceed.

At the end of the first year of operating the laser, wheat seed used 650 testing hours, corn seed used
900 hours, and 450 hours were idle.

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 Required:
1. From the firm’s point of view, what is the marginal cost of using an additional testing hour?

2. Single-rate method:
(i) Calculate the budgeted cost rate using
− practical capacity as the denominator

− total expected usage as the denominator

(ii) Given the single cost rate calculated above, what is the marginal cost of using an
additional testing hour from the wheat and corn managers’ perspective? Does the use of a

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single rate cause the testing service to look too expensive to the two user departments?

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3. The dual-rate method is essentially (i) a periodic charge (usually monthly) for the fixed cost
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associated with the capacity requested by the user department, and (ii) a charge for each unit
of actual service used based on the budgeted variable cost per unit of service.
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(i) Calculate the budgeted cost rate for fixed costs using
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− practical capacity as the denominator

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− total expected usage as the denominator

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(ii) What is the budgeted cost rate for variable costs?

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4.
Which method do you recommend? Give numerical illustrations of the laser testing costs
charged to wheat and corn under the single-rate and dual-rate methods.
Cost Allocation
Single Rate Dual Rate
Denominator Choice Wheat Corn Wheat Corn
$350,000 $350,000
* 700 *800
2,000 2,000
$193.8*650 $193.8*900 + $25 * 650 + $25 * 900
Using practical capacity: = $125,970 = $174,420 = $138,750 = $162,500
$350,000 $350,000
*700 *800
1,500 1,500
$258.3*650 $258.3*900 + $25 * 650 + $25 * 900
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Using expected usage: =$167,895 = $232,470 = $179,583 = $209,167
 • Common costs are costs that are shared by two or more users. These common costs must be
allocated in some equitable fashion.

The stand-alone cost-allocation method determines the weights for cost allocation by
considering each user of the cost as a separate entity. The cost is allocated among the users
based upon the total cost for each separately.

The incremental cost-allocation method ranks the individual users of the cost object in
the order of users most responsible for the common cost and uses this ranking to allocate
cost among those users. The first ranked user is the primary user and is assigned allocated
costs up to the cost as a stand-alone user. The second ranked user is the first incremental
user and is assigned cost equal to the additional cost that arises from having two users.
This continues until costs have been assigned to all users.

In-class Exercise 2: Allocation of common costs (15-24)

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Barbara Richardson, a self-employed consultant near Sacramento, received an invitation to visit a

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prospective client in Baltimore. A few days later, she received an invitation to make a presentation to

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a prospective client in Chicago. She decided to combine her visits, traveling from Sacramento to

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Baltimore, Baltimore to Chicago, and Chicago to Sacramento.
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Richardson received offers for her consulting services from both companies. Upon her return, she
decided to accept the engagement in Chicago. She is puzzled over how to allocate her travel costs
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between the two clients. She has collected the following data for regular round-trip fares with no
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stopovers:
Sacramento to Baltimore $900
Sacramento to Chicago $600
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Richardson paid $1,200 for her three-leg flight (Sacramento–Baltimore, Baltimore–Chicago, Chicago–
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Sacramento). In addition, she paid $30 each way for limousines from her home to Sacramento
Airport and back when she returned.
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Required:
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1. How should Richardson allocate the $1,200 airfare between the clients in Baltimore and
Chicago using (a) the stand-alone cost-allocation method, (b) the incremental cost-allocation
method, and (c) the Shapley value method?

a. The stand-alone cost allocation method. This method would allocate the air fare on the basis
of each client’s percentage of the total of the individual stand-alone costs.
$900
Baltimore client × $1,200 = $ 720
( $900 + $600 )
$600
Chicago client × $1,200 = 480
( $900 + $600 )
$1,200

Advocates of this method often emphasize an equity or fairness

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 b. The incremental cost allocation method. This requires the choice of a primary party and an
incremental party.

If the Baltimore client is the primary party, the allocation would be:
Baltimore client $ 900
Chicago client 300
$1,200

If the Chicago client is the primary party, the allocation would be:
Chicago client $ 600
Baltimore client 600
$1,200

One rationale is that the Chicago client is the one who is going to use Richardson’s services and,
presumably, receives more benefits from the travel expenditures.

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c. Richardson could calculate the Shapley value that considers each client in turn as the

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primary party: The Baltimore client is allocated $900 as the primary party and $600 as the

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incremental party for an average of ($900 + $600) ÷ 2 = $750. The Chicago client is allocated $600
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as the primary party and $300 as the incremental party for an average of ($600 + $300) ÷ 2 =
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$450. The Shapley value approach would allocate $750 to the Baltimore client and $450 to the
Chicago client.
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2. Which method would you recommend Richardson use and why?

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Richardson should use the Shapley value method. It is fairer than the incremental method because it
avoids considering one party as the primary party and allocating more of the common costs to that
party. It also avoids disputes about who is the primary party. It allocates costs in a manner that is close
to the costs allocated under the stand-alone method but takes a more comprehensive view of the
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common cost allocation problem by considering primary and incremental users, which the stand-
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alone method ignores.

The Shapley value (or the stand-alone cost allocation method) would be the preferred methods
if Richardson was to send the travel expenses to the Baltimore and Chicago clients before deciding
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which engagement to accept. Other factors such as whether to charge the Chicago client more because
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Richardson is accepting the Chicago engagement or the Baltimore client more because Richardson is
not going to work for them can be considered if Richardson sends in her travel expenses after making
her decision. However, each company would not want to be considered as the primary party and so
is likely to object to these arguments.

3. How should Richardson allocate the $60 limousine charges between the clients in Baltimore
and Chicago?

A simple approach is to split the $60 equally between the two clients. The limousine costs at the
Sacramento end are not a function of distance traveled on the plane.

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 An alternative approach is to add the $60 to the $1,200 and repeat requirement 1:

a. Stand-alone cost allocation method.

$960
Baltimore client × $1,260 = $746.67
( $960 + $660 )
$660
Chicago client × $1,260 = $513.33
( $960 + $660 )
b. Incremental cost allocation method.
With Baltimore client as the primary party:
Baltimore client $ 960
Chicago client 300
$1,260
With Chicago client as the primary party:
Chicago client $ 660
Baltimore client 600

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$1,260

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c. Shapley value.

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Baltimore client: ($960 + $600) ÷ 2 = $780

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Chicago client: ($300 + $660) ÷ 2 = $480
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As discussed in requirement 2, the Shapley value or the stand-alone cost allocation method would be
the preferred approaches.
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• Revenue allocation occurs when revenues are related to a particular revenue object but cannot
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be traced to it in an economically feasible manner. A bundled product is a package of two or

more products or services that is sold for a single price, but whose individual components may
be sold as separate items at their own stand-alone prices. In this case, revenues must be allocated
to the products included in the bundle.
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Under the stand-alone revenue allocation method the individual prices of each product
are used as weights to assign revenue to the product.
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Under the incremental revenue-allocation method, ranks of the individual products are
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assigned by management. This ranking is used to allocate bundled revenues to individual

products. The first ranked, or primary, product is assigned its full amount of revenues,
followed by the second ranked, or first incremental product, and so on.

In-class Exercise 3: Revenue allocation, bundled products (15-25)

Essence Company blends and sells designer fragrances. It has a Men’s Fragrances Division and a
Women’s Fragrances Division, each with different sales strategies, distribution channels, and product
offerings. Essence is now considering the sale of a bundled product called Sync consisting of one bottle
of Him, a men’s cologne, and one bottle of Her, a women’s perfume. For the most recent year, Essence
reported the following:
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 Required:
1. Allocate revenue from the sale of each unit of Sync to Him and Her using the following:
a. The stand-alone revenue-allocation method based on selling price of each product
b. The incremental revenue-allocation method, with Him ranked as the primary product
c. The incremental revenue-allocation method, with Her ranked as the primary product
d. The Shapley value method, assuming equal unit sales of Him and Her

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1a. Under the stand-alone revenue-allocation method based on selling price, Him will be allocated

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33.33% of all revenues, or $20 of the bundled selling price, and Her will be allocated 66.67% of all

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revenues, or $40 of the bundled selling price, as shown below.

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Stand-alone method, based on selling
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prices Him Her Total
Selling price $25 $50 $75
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Selling price as a % of total

($25 ÷ $75; $50 ÷ $75) 33.33% 66.67% 100%
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Allocation of $60 bundled selling price

(33.33% × $60; 66.67% × $60) $20 $40 $60

1b. Under the incremental revenue-allocation method, with Him ranked as the primary product,
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Him will be allocated $25 (its own stand-alone selling price), and Her will be allocated $35 of the $60
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selling price, as shown below.

Incremental Method
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(Him rank 1) Him Her

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Selling price $25 $50

Allocation of $60 bundled selling price
($25; $35 = $60 – $25) $25 $35

1c. Under the incremental revenue-allocation method, with Her ranked as the primary product,
Her will be allocated $50 (its own stand-alone selling price) and Him will be allocated $10 of the $60
selling price, as shown below.
Incremental Method
(Her rank 1) Him Her
Selling price $25 $50
Allocation of $60 bundled selling
price
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($10 = $60 – $50; $50) $10 $50
 1d. Under the Shapley value method, each product will be allocated the average of its allocations
in 1b and 1c, i.e., the average of its allocations when it is the primary product and when it is the
secondary product, as shown below.
Shapley Value Method Him Her
Allocation when Him = Rank 1;
Her = Rank 2 (from 1b.) $25.00 $35.00
Allocation when Her = Rank 1;
Him = Rank 2 (from 1c.) $10.00 $50.00
Average of allocated selling price
($25 + $10) ÷ 2; ($35 + $50) ÷ 2 $17.50 $42.50

2. Of the four methods in requirement 1, which one would you recommend for allocating Sync’s
revenues to Him and Her? Explain.
A summary of the allocations based on the four methods in requirement 1 is shown below.

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Stand-alone Incremental Incremental

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(Selling Prices) (Him first) (Her first) Shapley
Him $20 $25 $10 $17.50

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Her
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Total for Sync $60 $60 $60 $60.00

If there is no clear indication of which product is the more “important” product, or if it can be
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reasonably assumed that the two products are equally important to the company's strategy, the
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Shapley value method is the fairest of all the methods because it averages the effect of product rank.
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In this particular case, note that the allocations from the stand-alone method based on selling price are
reasonably similar to the allocations from the Shapley value method, so the managers at Essence may
well want to use the much simpler stand-alone method. The stand-alone method also does not require
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ranking the products in the suite, and so it is less likely to cause debates among product managers in
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the Men's and Women's Fragrance divisions. If, however, one of the products (Him or Her) is clearly
the product that is driving sales of the bundled product, then that product should be considered the
primary product or weighted more heavily (rather than equally) when applying the Shapley value
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method.
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For the next class, we will discuss how to allocate service department costs in situations where
service departments also serve each other. Please preview the rest of Chapter 15 and the next set of
lecture notes.

What do you need to know for the exam?

• Distinguish between the single-rate method from the dual-rate method

• Understand how divisional incentives are affected by alternative allocation choices.
• Understand how to allocate common costs using the stand-alone method, the incremental
method and the Shapley value method.
• Understand how bundling of products gives rise to revenue-allocation issues and the revenue
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allocation methods.
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