Measuring and Assigning Support Department Costs

From the time of the Industrial Revolution until the early 20th century, manufacturing operations were mainly labor intensive and direct costs comprised the majority of product costs. Since then, indirect costs in the form of automation have gradually replaced labor costs, and for many products are now the major component(s) of total product costs. This increased use of indirect
costs in manufacturing has increased the need for costing systems to deal adequately with indirect costs. Factory overhead allocation is so important
to obtain accurate cost information, especially in an automated manufacturing environment.

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

The most complicated stage in this cost allocation process is the second stage because support departments may provide services for other support departments as well as for production departments. For example, a personnel
department provides services for other support departments such as the power generating plant, maintenance department, and stores. The power generating department also provides heat and light for other support departments, including the personnel department and so on. When such interactions occur, the allocation process can become complicated. Difficulties arise because each support department begins to accumulate charges from other support departments from which it receives services, and these must be reallocated back to the user department. Once it has begun, this allocation and reallocation process can continue for a long time before a solution is found. Three different methods are used to solve this complex process. The direct method, stepdown method and reciprocal (algebraic) method can be used to allocate support departments’ costs to production departments.

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

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

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

The strategic role of cost allocation is linked to four objectives (Blocher, Stout, and Cokins, 2010: 232):
1. Determine accurate departmental and product costs as a basis for the evaluation of the cost efficiency of departments and the profitability of different products, for financial reporting, and for tax compliance.
2. Motivate executives for a high level of effort to achieve the goals targeted by senior management.
3. Right incentives are provided to the managers in order to make a decision
consistent with the objectives of the senior management.
4. Identify the fairly rewards that managers earn for their effectiveness in their decisions.
The first and most important objective requires the cost allocation method to be sufficiently accurate to support effective management decision making about products and departments. The management accountant recognizes that the
desired cost allocation method might differ for the three objectives: cost management, financial reporting, and tax compliance.
The second objective motivating managers mean that in order to be effective, cost allocation should reward department managers as desired to reduce costs. The main issue here is whether the administrator controls the assigned cost.
For example, if the cost allocation for a section’s equipment maintenance is based on the number of machine failures of the department, the administrator has the possibility to reduce them and thus reduce their maintenance costs because this is a controllable condition for the administrator. On the other hand, when the maintenance cost is allocated based on the square meters of a section,
the manager who does not influence the amount of floor space will not be motivated.
The third objective that provides incentives for decision-making is achieved when the cost allocation effectively empowers authorized individual managers to act autonomously with the goals of the senior management. One of the biggest
advantages of cost allocation methods is to attract managers’ attention to common facilities. The cost allocation provides an incentive for individual efforts to encourage managers to plan, manage, and improve the performance of these facilities.

The fourth objective, impartiality, is met when cost allocation is implemented in an explicit and objective manner. The most objective approach for cost allocation occurs when the cause-effect relationship can be established. For example, based on the number of failures of machinery, the allocation of maintenance costs is more objective and fair than an allocation based on the number of
square meters, the number of products produced, or the labor costs in the department. This situation should be evaluated in terms of a cause-effect relationship. While there is a logical relationship between maintenance costs and the number of failures, there is no clear relationship between labor costs and maintenance costs (Blocher, Stout, and Cokins, 2010: 232-233).

Indirect costs are not directly identified with a cost object. Indirect costs of a particular cost object are costs that are related to that cost object but cannot be traced to it in an economically feasible or cost-effective way. Indirect costs often comprise a sizable percentage of the costs assigned to cost objects such as products, distribution channels, and customers.

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

An operating department performs the actual manufacturing operations that physically change the units being processed. Because the operating departments receive the benefit of the work performed by the support departments, the total cost of production must include not only the costs incurred directly in the operating departments but also a portion of the costs of operating the service departments. Therefore, the total product costs should include a share of support department costs.

A support department is an essential part of the organization, but it does not work directly on the product. The product indirectly receives the benefit of the work performed by the support department. Examples of support departments include a department that generates power for the factory and a building maintenance department that is responsible for maintaining the buildings.

An operating department (also called a production department in manufacturing companies) adds value to a product or service that is observable by a customer. These departments are directly responsible for creating the products or services sold to customers. In a large accounting firm, examples of operating departments are auditing, tax, and management advisory services. In a manufacturing setting such as an automobile manufacturer, production departments are those that work directly on the products being manufactured (e.g., assembly and painting).

A support department (also called a service department) provides the services that maintain other internal departments (operating departments and other
support departments) in the organization. These departments provide basic and supportive services for operating departments. These departments are therefore
indirectly linked to the services or products of the enterprise. At an automobile manufacturer company, those departments might include engineering, maintenance, and personnel (Guan, Hansen and Mowen, 2006: 210).

The departmental cost allocation approach has three stages:

(1) trace all direct manufacturing costs and allocate manufacturing overhead costs to both the support departments and the operating departments,

(2) allocate the support department costs to the operating departments, and finally,
(3) allocate the operating department costs to the products (Blocher, Stout, and Cokins, 2010: 234).

The first stage in the departmental allocation approach traces the direct costs and allocates the indirect manufacturing costs in the organization to each support and production department.
The second stage allocates support department costs to the production departments. This is the most complex of the allocation stages because services can flow back and forth between the support departments. These are often called reciprocal flows. For example, assume that 40 percent (720 hours) of Support Department 1’s 1,800 labor-hours are spent serving Support Department 2. Also, assume that 10 percent of Support Department 2’s time is spent serving Support Department 1. The percentage of service relationships is commonly determined by reference to labor hours, units processed, or some other allocation base that best reflects the service provided in the departments.
Accountants use three common methods to allocate costs for the second stage: (1) the direct method, (2) the step-down method, and (3) the reciprocal method.
The third stage in the departmental allocation approach allocates the production departments to products.

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

There are two important issues in calculating the charging rate:
1. The choice of a single or a dual charging rate and,
2. The use of budgeted versus actual support department costs.

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

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

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

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

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

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

Three allocation methods can be used to allocate support departments costs to operating departments:
• Direct method
• Step-down method
• Reciprocal method

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

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

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

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