CHAPTER 15

SUPPORT DEPARTMENT, COMMON COST, AND

REVENUE ALLOCATIONS
LEARNING OBJECTIVES

1. Differentiate the single-rate from the dual-rate cost-allocation method

2. Understand how the uncertainty managers face is affected by the choice between budgeted and actual
cost-allocation rates

3. Allocate support department costs using the direct, step-down, and reciprocal methods

4. Allocate common costs using either the stand-alone or the incremental method

5. Explain the importance of explicit agreement between contracting parties when reimbursement is
based on costs incurred

6. Understand how bundling of products gives rise to revenue-allocation issues

7. Allocate the revenues of a bundled package to the individual products in that package

CHAPTER OVERVIEW
Chapter 15 continues the study of the allocation of indirect costson the micro/application level. The
concept of cost allocation was introduced in Chapter 2 in relation to a cost object. A review of that
information might be helpful at the beginning of the study of this chapter. In Chapter 4, cost allocation
becomes a focus. The costing of a product or service using a normal costing system emphasizes the
application of the allocation concept. Again, the topic of cost allocation is studied through activity-based
costing presented in Chapter 5. With the introduction of budgets and standards, cost allocation is a main
subject (Chapter 8). The first lines of this chapter recognize the pervasiveness of the topic and the
difficulty in finding satisfactory answers to questions about cost allocation. Chapter 14 gives the purpose
for which cost is allocated as the starting point in the allocation process.

Three specific methods, direct, step-down, and reciprocal, for allocating costs of service or support
departments to operating or production departments are described and illustrated. Two other methods for
allocating common costs are also presentedstand-alone and incremental. Importantly, the text covers
the why and how of cost allocation between business segments.

Contract disputes that arise over the allocation of costs are also addressed.

Allocation is a pervasive concept and its application to revenues is included. The bundling of multiple
products to sell for a single price requires allocation of that price if a manager is to be held responsible for
individual product revenues or profits or if bonuses are calculated on individual products. The two
methods illustrated for revenue allocation are methods used for allocation of costsstand-alone method
and incremental method. Examples are used to explain details of each method.

Support Department, Common Costs, and Revenue Allocations 201

CHAPTER OUTLINE
TEACHING TIP: In Chapter 4, the basic method by which costs are allocated was introduced as primary
to a normal costing system. In Chapter 8, the basic is changed to incorporate standards.

Allocation amount = Allocation rate x Usage of cost allocation base

The following portion of the outline addresses the elements of this formula. To allocate or not to allocate
a particular cost is the first question. Other questions follow: how to group costs to be allocated, what to
use as the cost-allocation base, should cost behavior (fixed and variable) be incorporated into the
allocation process, should the costs and cost-allocation levels used for the rate be budgeted ones or actual
amounts, should the usage amount by which the rate is multiplied be budgeted or actual amounts, and
what specific method to usedirect to primary unit, step-down through other groupings on way to
primary unit, or reciprocal of secondary groups sharing with each other to find amount for primary group?

I. Allocation formula issues

Learning Objective 1:
Differentiate the single-rate from the dual-rate cost-allocation method

A. Different methods of allocating fixed and variable costs: one rate for mixed cost or two rates
using one for fixed costs and one for variable costs

1. Single-rate cost-allocation method

a. Pools all costs regardless of behavior in a cost pool

b. Allocates to cost object using same rate per unit of single allocation base

c. Cost to implement is lowavoids often expensive analysis to classify individual cost

items into fixed and variable categories

d. Often leads to decisions in own best interests of individual manager but not best interest
for organization as a whole

2. Dual-rate cost-allocation method

a. Pools cost into two separate cost pools according to behaviorfixed and variable

b. Allocates to cost object with each cost pool using different cost-allocation base

c. Signals to managers how costs behave differently

d. Provides better information for making decisions (should be method used)

Do multiple choice 1. Assign Exercise 15-16.

Learning Objective 2:

202 Chapter 15
Understand how the uncertainty managers face is affected by the choice between budgeted and actual
cost-allocation rates

B. Different rates to use for allocation: budgeted cost rates or actual cost rates

1. Budgeted cost rates

a. Rates known in advance reduce uncertainty

b. Users can determine amount of service to request as rates known in advance

c. Managers motivated to improve efficiency bear risk of unfavorable cost variances

2. Actual cost rates

a. Rates not known until end of period

b. Amounts allocated fluctuate so users bear the risk

C. Different usage quantities of fixed costs in allocating: budgeted or actual quantities [Exhibit 15-
1]

1. Budgeted quantity usage

a. Helps in planning, especially for long run

b. Unaffected by variations in other divisions

c. Requires realistic estimates, accurate forecasts

2. Actual quantity usagenot known until end of period

3. Practical capacity supplied

a. Each division only charges for actual use

b. Variations in actual use in one division do not affect costs allocated to other divisions

c. Costs of unused capacity are highlighted and not allocated to user divisions

Do multiple choice 2. Assign Exercises 15-17 and 15-18 and Problems 15-28 and15-30.

II. Allocation methods to use for reciprocal relationships

A. Distinguishing between types of departments within an organization

1. Operating department or production department: directly adds value to a product or

service

2. Support department or service department

Support Department, Common Costs, and Revenue Allocations 203

 a. Assists other internal departments in the company

b. Creates special allocation problems when providing reciprocal support to each other as
well as operating departments

c. Results in more accurate costs of products, services, and customers when more accurate
in support department allocations [Exhibit 15-2]

Learning Objective 3:
Allocate support department costs using the direct, step-down, and reciprocal methods

B. Distinguishing among specific allocation methods for allocating support costs

1. Direct allocation method [Exhibit 15-3]

a. Most widely used method of allocating support department costs

b. Allocates each support departments costs directly to operating departments

c. Benefit of simplicity

d. Disadvantage is failure to recognize reciprocal services provided among support

departments

2. Step-down allocation method (also called sequential allocation method) [Exhibit 15-4]

a. Allows for partial recognition of services rendered by support departments to other

support departments

b. Requires support departments to be ranked (sequenced) in the order of the allocation

c. Often uses department with highest percentage of its total services to other service
departments to start allocation sequence, with next-highest following, etc.

d. Does not recognize total services that support departments provide each other

3. Reciprocal allocation method [Exhibit 15-5]

a. Allocates costs by explicitly including mutual services provided among all support
departments

b. Conceptually most precise method because considers mutual services provided among all
support departments

c. Highlights complete reciprocated costs of support departments and how those costs differ
from budgeted or actual costs of departmentskey input for decisions about outsourcing

d. Requires three steps: [Exhibit 15-6]

i. Step 1: Express support department costs and support department reciprocal

relationships in the form of linear equations

204 Chapter 15
 ii. Step 2: Solve the set of linear equations to obtain the complete reciprocated costs of
each support department

iii. Step 3: Allocate the complete reciprocated costs of each support department to
all other departments (both support departments and operating departments) on the
basis of the usage percentages (based on total units of service provided to all
departments)
[Surveys of Company Practice]

TEACHING TIP: Use a sentence in words about the costs of a support department before developing the
equation. From the text examplethe full cost of the Plant Maintenance support department is or equals
$600,000 plus costs used by Plant Maintenance that were supplied by Information Systems. (The terms of
used by [use column] and supplied by [use row] are helpful when using the format of exercises and
problems in the text.) Substituting mathematical symbols in place of the words will develop the equation.

Do multiple choice 3, 4, and 5. Assign Exercises 15-19 (20) and 15-21 (22) and Problems 15-
31,
15-32, and 15-33.

III. Methods of allocating common costs

A. Common cost: cost of operating a facility, activity, or like cost object that is shared by two or
more users

Learning Objective 4:
Allocate common costs using either the stand-alone or incremental method

B. Methods for allocating

1. Stand-alone cost-allocation method

a. Uses information pertaining to each user of a cost object as a separate entity to determine
the cost-allocation weights

b. Emphasizes fairness or equity criterion because each user bears a proportionate share of
total costs in relation to individual stand-alone costs

2. Incremental cost-allocation method

a. Ranks individual users of a cost object in order of users most responsible for the common
costs, then uses this ranking to allocate costs among users

b. Disputes as to which is incremental user

3. A cautionchosen method of allocation should be acceptable to each user

Do multiple choice 6. Assign Exercises 15-23 and 15-24.

Support Department, Common Costs, and Revenue Allocations 205

Learning Objective 5:
Explain the importance of explicit agreement between contracting parties when reimbursement is based
on costs incurred

IV. Cost allocation and Contracts

A. Reduce disputes by making rules of the game explicit and in writing at time of contract signing

1. Definition of cost items allowed

2. Definition of terms used

3. Permissible cost-allocation bases

4. Handling of accounting for differences between budgeted and actual costs

B. Complex interplay of political considerations and accounting principles

1. Reimbursement: contractor paid set price without analysis of actual contract cost data

a. Competitive bidding

b. Adequate price competition

c. Established catalog with prices quoted for items sold in substantial quantities to general
public

2. Reimbursement: contractor paid after analysis of actual contract cost data: cost-plus contract

a. Compliance with Cost Accounting Standards Board: for uniformity and consistency in
regard to measurement, assignment, and allocation of costs

b. Terms such as fairness and equity often used along with cause and effect and benefits
received

C. Fairness of pricing [Concepts in Action]

1. Costs-plus-fixed-fee contracts

a. Initiating party assumes major share of risk of potentially high costs of completing
contract

b. Use of allowable costs: cost contract parties agree to include in costs to be reimbursed

Do multiple choice 7. Assign Problem 15-35.

TEACHING TIP: In calculating proportions or weights to use in allocating, it is sometimes helpful to

remind students that order is not important in multiplication and division. The amount of cost allocated
will be the same whether one uses the sequence
(individual amount/total amount) (proportion) x cost to be allocated = allocated cost or

206 Chapter 15
 (individual amount x cost to be allocated) / total amount = allocated cost or
individual amount x (cost to be allocated/total amount) (rate) = allocated cost.

I. Revenues

A. Essential to profit

B. Important to managers

1. Revenue planning

2. Revenue analysis

V. Revenue allocation

Learning Objective 6:
Understand how bundling of products gives rise to revenue-allocation issues

A. Revenue allocation and bundled products

1. Definitions

a. Revenue allocation: assigning of revenues that are related, but cannot be traced in an
economically feasible way to revenue object

b. Revenue object: anything for which a separate measurement of revenue is desired

c. Bundled product: package of two or more products or services, sold for a single price,
but individual components of the bundle may be sold as separate items at their stand-
alone prices

2. Issues

a. Single price for bundled product typically less than sum of prices of individual products
sold separately

b. Separate measurement (allocation) of revenue by product if manager responsible for

individual product revenues or profits

Do multiple choice 8. Assignment follows L. O. 8.

Learning Objective 7:
Allocate the revenues of a bundled package to the individual products in that package

B. Revenue allocation methods

1. Stand-alone revenue-allocation method

a. Description: uses product-specific information on products in the bundle as weights for

allocating bundled revenues to individual products

Support Department, Common Costs, and Revenue Allocations 207

 b. Weights

i. Selling prices

ii. Unit costs

iii. Physical units in which each unit has the same weight

iv. Stand-alone product revenues

c. Advantages

i. Revenue as weightselling price and stand-alone product revenues

Use of benefits-received criterion (revenue as benefit)

More weight to product that generates more revenue and drives sale of bundled
products

ii. Physical units as weight

Ease of use

Less limitations than other methods if costs difficult to calculate or selling prices
unstable

2. Incremental revenue allocation method

a. Description: ranks individual products in a bundle according to criteria determined by
management, then uses ranking to allocate the bundled revenues to the individual
products
b. Ranking
i. Terms: first-ranked is primary product, second-ranked is first incremental product,
third-ranked is second incremental product
ii. Criterion

Survey of customers as to relative importance of individual products in decision

to purchase bundled products

Data on recent stand-alone performance of the individual products in the bundle

Top managers use their knowledge or intuition to decide the rankings

iii. Comparison to stand-alone method: stand-alone method less likely to cause

acrimonious debates among product managers
c. Management judgment not explicitly based on specific formula
Do multiple choice 9 and 10. Assign Exercise 15-25 and Problem 15-34.

208 Chapter 15
CHAPTER QUIZ SOLUTIONS: 1.d 2.c 3.a 4.c 5.d 6.b 7.b 8.a 9.b 10.a

CHAPTER QUIZ
1. The use of a dual-rate cost-allocation method recognizes
a. the improvements in technology allowing for use of multiple cost pools.
b. the need to use both budgeted and actual cost rates when allocating.
c. the need to use both budgeted and actual usage of quantities when allocating.
d. the behavior aspect of costs.
2. Managers are affected by risks they have to take and would prefer to use
a. actual rates for cost allocation because the rates are calculated from real amounts.
b. actual rates for cost allocation because actual rates are easier to justify to users.
c. budgeted rates for cost allocation because the rates are known in advance.
d. budgeted rates for cost allocation because any variances are transferred to users.
The following data apply to questions 35.
Billy Stone, Inc., budgets the following amounts for its Buildings & Grounds and Computer Services
Departments in servicing each other and the two manufacturing divisions of Signs and Mailers:
Used By
Supplied By Building & Grounds Computer Services Signs Mailers
Buildings & Grounds 0.20 0.60 0.20
Computer Services 0.15 0.30 0.55

The actual results for the time period were as follows:

Used By
Supplied By Building & Grounds Computer Services Signs Mailers
Buildings & Grounds 0.10 0.60 0.30
Computer Services 0.25 0.35 0.40
Actual cost data for each department are:
Fixed Variable
Buildings & Grounds $ 50,000 $90,000
Computer Services $100,000 $21,000
3. Total fixed costs allocated from Buildings & Grounds to the Signs Department, using the preferred
allocation basis, by the direct allocation method are
a. $37,500. b. $33,333. c. $30,000. d. $25,000.
4. Total variable costs allocated from Computer Services to Mailers Department, using the preferred
allocation basis, by the step-down allocation method (begin with Building & Grounds) are
a. $8,400. b. $12,000. c. $16,000. d. $25,235.
5. The equation to determine the total variable costs of Computer Services using the preferred allocation
basis, for the reciprocal allocation method is

Support Department, Common Costs, and Revenue Allocations 209

 a. CS = $21,000 + 0.25 B&G. c. CS = $21,000 + 0.15 B&G.
b. CS = $21,000 + 0.20 B&G. d. CS = $21,000 + 0.10 B&G.

6. If a cost is incurred for more than one user, that cost is considered a(n)

a. homogeneous cost.
b. common cost.
c. stand-alone cost.
d. incremental cost.

7. Which of the following is often the most basic cause of contract disputes?

a. allowable costs
b. cost-allocation issues
c. use of common costs
d. writing into the contract rules of the game

8. Bundling of products creates the need for revenue allocation for each of the following except when

a. selling prices for the bundle are set to recoup the stand-alone prices of each product in the bundle.
b. the manager is responsible for profitability on a product-by-product basis.
c. the managers bonus is based upon product profitability.
d. persons involved with product development are compensated by percentage of revenues realized.

Use the following information for questions 9 and 10.

Trio Company sells three products, Do, Ra, and Mi, for prices of $8, $7, and $5, respectively. They also
offer combinations of the products for reduced overall prices. The following packages are available: (1) a
package containing Do and Ra sells for $13.50, (2) a package of Do and Mi sells for $11.50, (3) a
package containing Ra and Mi sells for $10.50, and (4) a package of all three products, Do, Ra, and Mi,
sells for $17.00.

9. If Trio Company uses the stand-alone method (based on selling prices) to allocate revenues to
products, the amount of revenues to be allocated to Do from a package of all three products, as
described in (4) above, sold would be

a. $8.00. b. $6.80. c. $5.95. d. $4.25.

10. If Trio Company uses the incremental-revenues allocation method and has designated Ra as the
primary product, the amount of revenues from a bundled package of all three products to be allocated
to Ra would be

a. $7.00. b. $6.80. c. $5,95. d. $4.25.

210 Chapter 15
WRITING/DISCUSSION EXERCISES
1. Differentiate the single-rate from the dual-rate cost-allocation method

Is the caution to beware of unit costs applicable to the single-rate cost-allocation

method? Why or why not? The caution is probably applicable. The situation could exist such that
the indirect costs to be allocated were homogeneous, all variable in behavior, and linked in a cause-and-
effect manner to the same cost-allocation base. If such a situation existed, the single rate would probably
work. A test could be applied: if the costs were individually allocated, would they require the use of the
same cost-allocation base? If the answer were yes, then a single pool would be appropriate. However,
the caution of using a single rate (unit cost) pertains to unitizing fixed costs. Fixed costs, by definition,
stay the same in total but vary per unit. The cost pool from which the single rate would be calculated
could contain some fixed costsand the caution would apply.

2. Understand how the uncertainty managers face are affected by the choice between budgeted
and actual cost-allocation rates

What has the manager of a supplier department to lose when s/he is not directly affecting
the product or service? Managers of supplier or support departments are at risk when the actual
costs of their department exceed their budgeted costs. If a budgeted rate is used, a manager risks actual
costs of providing the service being greater than the budget amount with no one to pass those additional
costs on to. Another risk for a manager is that the users of the departments service will go elsewhere to
buy the service, and department costs will exceed revenues. If the excess costs are due to events over
which the manager has no control, some arrangement could be made so the manager does not have the
full burden. In some instances, top management may wish to provide various incentives that would
benefit the organization as a whole, but might be viewed negatively by an individual manager.
Agreements could be made to share the risk across departments rather than have only one manager
responsible.

3. Allocate support department costs using the direct, step-down, and reciprocal methods

Why is it so important that managers have some understanding of cost accounting?

The statement will often be made that one method has an advantage of being relatively simple to compute
and understand as opposed to some other method. The simple method is usually the one most in use. This
would lead one to believe that when using the cost/benefit approach, more often the easier method is best.
Consider the reciprocal method for allocating costs. It is the superior method for accuracy of capturing
interdepartmental relationships, resulting in better-informed decisions about the performance of a
department and the company as a whole. Yet, the reciprocal method is not widely used. A defense for
nonuse could be made before technology became available and common. If a manager is aware that by
using more sophisticated models, s/he will gain greater benefits, their use should be required. The
learning necessary to glean full advantage would carry a cost, but that cost would be less than the reward
furnished by the knowledge available in the long run.

Support Department, Common Costs, and Revenue Allocations 211

4. Allocate common costs using either the stand-alone or incremental method

Give an example of a situation in which two or more users share a common cost and
offer a way for the users to share the cost. Many examples are possible. The method by which
the cost could be shared would probably be some version of either the stand-alone or incremental
methods. One example is buying a box of items at an auction. One person, for the benefit of several
other persons, made the purchase. Each person wanted one or two items (no one wanted the same item) in
the box. In this situation, the cost of the box must be allocated among the various partakers of the items
in the box because none of the cost could be traced to an individual item. Common costs are typically
package deals and are less in amount for the users than if each user acted alonerequiring allocation.

5. Explain the importance of explicit agreement between contracting parties when

reimbursement is based on costs incurred

How does the phrase hindsight has 20/20 vision apply to contract disputes having to
do with cost allocation? Before the work contracted for is commenced, all of the situations and
problems cannot be anticipated. Usually neither party wants to assume all of the risk, so if loss does
occur, the question of how that loss is to be shared is fraught with controversy. In some situations, cultural
traditions or taboos are not negotiated ahead of signing the contract because the one party assumes that
anyone would know and understand them, whereas the other party is unaware that such customs or taboos
exist. In the process of doing the work, if a cost is incurred that violates a tradition, a disagreement will
occur as to the propriety of the cost and who will bear it. Many other possibilities for disagreement exist
as to which party bears a cost when reimbursement is based on costs incurred even when an explicit
agreement exists between parties.

6. Understand how bundling of products gives rise to revenue-allocation issues

Revenue assignment to a revenue object involves both revenue tracing and revenue
allocation. Revenue tracing occurs where revenues can be identified with an individual
product, service, or customer in an economically feasible way. What is done with
deductions in revenue, such as sales returns, when revenues are traced to revenue
objects? Revenue tracing, like cost tracing, results in more accurate assignment of revenues to
products than revenue allocation. More accurate revenue assignment results in more accurate
information; more accurate information is believed to result in better decisions. Any revenue-related
items should also be traced to the related revenue object. If revenue-related items, such as sales returns,
are not traced but rather broadly averaged across all products, the information is not as accurate and
affects decisions made. As is noted in the text, the detail of records maintained about price-discounting
affects the ability to do customer profitability analysis [Refer to Chapter 14]. The accuracy and detail of
tracing revenues and revenue-related items, such as sales returns, also affect customer profitability
analysis.

212 Chapter 15
7. Allocate the revenues of a bundled package to the individual products in that package

How does the illustration in the text [Other Revenue-Allocation Methods] of the
president of a software company determining the revenue allocation weights for use with
incremental method of allocating revenues reinforce the key guideline for management
accounting that management is primarily a human activity? A management accounting
system should improve the decisions made by managers and help motivate managers (and others) to
achieve the companys goals. An important guideline in helping management accountants provide the
most value in performing their functions is that of focusing on behavioral considerationshow to help
individuals do their jobs better. In situations in which the need exists for revenue allocation, specific
formulae, such as used in the stand-alone allocation method, are helpful management tools. Factors, other
than those incorporated in such formulae, may need to be considered. Management judgment, a human
activity, is needed. The use of some methods is more dependent upon management judgment, the
incremental allocation method as one example. The specific example in the text illustrates the human
element of difference of opinion between managers. The accounting tool of incremental revenue
allocation method existed to provide helpful information for making decisions but its implementation had
to be handled primarily as a human activity and not an accounting procedure.

Support Department, Common Costs, and Revenue Allocations 213

SUGGESTED READINGS
Anthony, R., Cost Allocation, Journal of Cost Analysis (Spring 1984) p.5 [11p].

Balakrishnan, R. and DeJong, D., The Role of Cost Allocation in the Acquisition and Use of Common
Resources, The Accounting Review (July 1993) p.395 [20p].

Ingram, R., Parsons, W., and Robbins, W., Instructional Case: Oak Citys Cost Allocation and
Determination, Issues in Accounting Education (February 1998) p.157 [15p].

Savage, K. and Wilburn, N., Teaching the Reciprocal Method of ServiceDepartment Cost Allocation
Using a Spreadsheet Approach, Accounting Educators Journal (Fall 1997) p.142 [14p].

Sharma, R. and Ratnatunga, J., Teaching Note: Traditional and Activity-Based Costing Systems,
Accounting Education (December 1997) p.337 [19p].

Sutcliffe, C., Aggregation and Reciprocal Service Cost Allocation, Journal of Business Finance &
Accounting (September 1991) p.721 [13p].

214 Chapter 15