CA 5107 – COST ACCOUNTING & CONTROL

Module 2 – Factory Overhead – Service Costs Allocation and Activity-Based Costing

Service Costs Allocation

Service or support department is a unit in an organization that contributes in a very indirect way to the
conversion of raw materials in a finished product. These units are the purchasing, personnel, warehousing
and maintenance department. Since these departments support the production department, the costs
incurred must be allocated to production departments to determine the full costs of a product.

Services Costs Allocation Methods

A. Direct Method – The direct method is considered the simplest method of allocating the cost of
service departments to operating departments. Under this method, the costs incurred by service
departments are not allocated to each other; rather, they are directly allocated to operating
departments using some appropriate allocation base. In other words, we can say that the direct
method of departmental cost allocation ignores the service provided by a service department to
itself and to other service departments.

B. Step Method – The step allocation method is an approach used to allocate the cost of the services
provided by one service department to another service department. The essential steps in this
allocation process are:

1. The service department that provides service to the largest number of other service departments
or which has the largest percentage of its costs consumed by other service departments allocates
its costs to them first. It also allocates its other costs to the operating departments.

2. The service department that provides service to the next-largest number of other service
departments or which has the second-largest percentage of its costs consumed by other service
departments allocates its costs. Again, its other costs are allocated to the operating departments at
this time.

3. The process continues until the service department that provides service to the smallest number of
other service departments or has the smallest percentage of its costs consumed by other service
departments has allocated its costs. Once these allocations have been completed, the process
stops.

C. Algebraic Method – The reciprocal method uses simultaneous equations to allocate the costs
incurred by service departments to other departments; allocations are also made between the
service departments. This method results in an accurate distribution of costs. The method is rarely
used, since there are somewhat less accurate methods available that require fewer calculations.
This method is also known as Reciprocal or Simultaneous Method.

Illustration: The Quarantine Manufacturing has two service departments (I.T. and Maintenance) and two
producing departments (Forming and Finishing).

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 Service Departments Operating Departments
I.T. Maintenance Forming Finishing
Direct costs P 150 P 300
Services performed by I.T. 40% 40% 20%
Services performed by Maintenance 20% 70% 10%

Required: Compute the allocated cost to departments Forming and Finishing using the following
method:

1. Direct method
2. Step-down method (cost of department I.T. is allocated first)
3. Step-down method (cost of department Maintenance is allocated first)
4. Reciprocal method

1) Direct Method
Service Departments Operating Departments
I.T. Maintenance Forming Finishing
Direct costs P 150 P 300
Services performed by I.T. (150) 100.00 (4/6) 50.00 (2/6)
Services performed by Maintenance (300) 262.50 (7/8) 37.50 (1/8)
362.50 87.50

2) Step-down method (cost of department I.T. is allocated first)

Service Departments Operating Departments

I.T. Maintenance Forming Finishing
Direct costs P 150 P 300
Services performed by I.T. (150) 60 (40%) 60.00 (40%) 30.00 (20%)
Services performed by Maintenance (360) 315.00 (7/8) 45.00 (1/8)
375.00 75.00

3) Step-down method (cost of department Maintenance is allocated first)

Service Departments Operating Departments

I.T. Maintenance Forming Finishing
Direct costs P 150 P 300
Services performed by Maintenance 60 (20%) (300) 210.00 (70%) 30.00 (10%)
Services performed by I.T. (210) 140.00 (40/60) 70.00 (20/60)
350.00 100.00

4) Reciprocal method

Equation:

IT = 150 + 20% Maintenance

Maintenance = 300 + 40% IT

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 IT = 150 + 20% (300 + 40% IT)
= 150 + 60 + 8% IT
92% IT = 210
IT = 210/92%
IT = 228.26

Maintenance = 300 + 40% (228.26)

= 300 + 91.30
= 391.30

Service Departments Operating Departments

I.T. Maintenance Forming Finishing
Direct costs P 150.00 P 300.00
Services performed by I.T. (228.26) 91.30(40%) 91.30(40%) 45.65 (20%)
Services performed by Maintenance 78.26(20%) (391.30) 273.91 (70%) 39.13 (10%)
365.21 84.78

ACTIVITY-BASED COSTING

Activity-Based Costing (ABC) is a systematic costing method that uses activities to allocate factory
overhead costs and other indirect costs to products. ABC can provide more accurate data on product cost
by using multiple cost drivers that reflect more accurately the causes of incurred costs.

ABC vs. TRADITIONAL COSTING

Under the traditional costing, factory overhead costs are allocated to products by using a single activity or
cost driver (e.g., labor hours). In some accounting literature, traditional costing is also called peanut-
butter costing.

Under ABC, factory overhead costs are allocated to products using several activities or cost drivers that
are closely related with the incurrence of specific factory overhead costs.

STEPS IN IMPLEMENTING ABC:

STEP 1: Perform PROCESS VALUE analysis – identifying value-added vs. non value-added activities.

A value-added activity is a non-eliminable activity that incurs costs but increases the worth of the product
to the customer. (e.g., engineering designs modification)

A non-value-added activity increases the cost of a product but does not increase its value to customers.
(e.g., materials handling and rework)

Illustration: Value-Added and Non-Value-Added Activities

Consider the activities that follow then categorize each of these as either value-added or non-value-added:

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 1. Developing computer coding for a new spreadsheet package
2. Painting the office of a maintenance supervisor at a plant that produces cereal
3. Examining a new patient
4. The 90 minutes that a Boeing 757 sits idle on the ground between flights
5. Moving cases of paper from one location to another in the same warehouse
6. Attaching a watch band to the watch’s face
7. Reprocessing mail that had been sorted incorrectly on a malfunctioning sorting machine.
8. Correcting errors made by company personnel in customer accounts
9. Upgrading the quality of bedding used at hotels in very competitive marketplaces
10. Attaching the engine to the mower's body.
11. Installing a new air-conditioning system in the executive offices.
12. Replacing a defective wheel with a new wheel.
13. Designing and printing an owner's instruction manual for a new model.
14. Moving completed mowers to the finished-goods warehouse.
15. Attaching the handle to the mower's body. The process took longer than normal because of a
worker slowdown caused by disgruntled employees.

ANSWERS:

1. Value-added
2. Nonvalue-added
3. Value-added
4. Nonvalue-added
5. Nonvalue-added
6. Value-added
7. Nonvalue-added
8. Nonvalue-added
9. Value-added
10. Value-added
11. Nonvalue-added
12. Nonvalue-added
13. Value-added
14. Nonvalue-added
15. First Sentence – Value-added; Second Sentence – Nonvalue-added

STEP 2: Identify cost drivers (activities), cost pools and activity centers.

 A cost driver is the particular activity that causes the incurrence of certain costs.

 A cost pool is a group of similar costs usually increased or decreased by a single cost driver.

 An activity center is a unit of organization that performs a set of tasks. It is a part of the production
process for which management wants a separate reporting of the cost of the activity involved. Level
of activity centers can be classified into four general categories:

A) Unit-level activities – are performed each time a unit is produced

B) Batch-level activities – are performed each time a batch of goods is handled or processed

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 C) Product-level activities – are performed to support production (sales) of specific product type

D) Facility-level activities – are performed to sustain a facility’s manufacturing process

Illustration: Activity Levels

Determine the appropriate level for each of the following activities. Indicate whether the activity is unit-
level (UL), batch-level (BL), product-level (PL), facility-level (FL):

1. Equipment set-ups
2. Machine hours
3. Plant supervision and landscaping
4. Indirect materials
5. Prime cost
6. Safety costs at winery
7. Packaging and shipment
8. Truckload shipping costs
9. Advertising
10. Building maintenance costs
11. Heating, lighting and security
12. Bottle and cork cost
13. Designing and changing
14. Development cost of new after-dinner wine
15. Product order processing
16. Tasting and testing costs

ANSWERS:

1. Equipment set-ups (BL)

2. Machine hours (UL)
3. Plant supervision and landscaping (FL)
4. Indirect materials (UL)
5. Prime cost (UL)
6. Safety costs at winery FL
7. Packaging and shipment (BL)
8. Truckload shipping costs BL
9. Advertising (PL)
10. Building maintenance costs FL
11. Heating, lighting and security (FL)
12. Bottle and cork cost UL
13. Designing and changing (PL)
14. Development cost of new after-dinner wine (PL)
15. Product order processing (BL)
16. Tasting and testing costs BL

STEP 3: Calculate predetermined overhead rates for each identified activity.

Predetermined overhead rate = Estimated overhead costs ÷ Estimated activity level

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NOTE: Estimated figures are used because actual figures are not yet known at the start of the period.

STEP 4: Allocate overhead costs to the products on the basis of predetermined overhead rates.

In summary, ABC is a ‘two-stage’ allocation process. First, overhead costs are traced to activities; then,
overhead costs are allocated to products on the basis of the activities performed by a particular product.

Illustration: Activity-Based Costing

Corona Company has identified activity centers to which overhead costs are assigned. The cost pool
amounts for these centers and their selected activity drivers for 2020 are as follows:

Activity Centers Costs Activity Drivers

Utilities P 300,000 60,000 machine hours
Scheduling and setup 273,000 780 setups
Material handling 640,000 1,600,000 pounds of materials

The company’s products and other operating statistics follow:

PRODUCTS
ISKO VICO JOY
Direct costs P 80,000 P 80,000 P 90,000
Machine hours 30,000 10,000 20,000
Number of setups 130 380 270
Pounds of materials 500,000 300,000 800,000
Number of units produced 40,000 20,000 60,000
Direct labor hours 32,000 18,000 50,000

Required:

1. Determine the pool rates

2. Allocate the overhead using the pool rates determined above
3. Determine the total cost of the job

ANSWERS:

1. Pool rates:

Activity Centers Costs Activity Drivers Pool Rates

Utilities P 300,000 60,000 machine hours P5/MH
Scheduling and setup 273,000 780 setups P350/setup
Material handling 640,000 1,600,000 pounds P0.40/lb

2. Overhead allocations:

PRODUCTS
ISKO VICO JOY
Utilities

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 Isko: P5 x 30,000 MH P 150,000
Vico: P5 x 10,000 MH P 50,000
Joy: P5 x 20,000 MH P 100,000
Scheduling and setup
Isko: P350 x 130 setups 45,500
Vico: P350 x 380 setups 133,000
Joy: P350 x 270 setups 94,500
Material handling
Isko: P0.40 x 500,000 lbs. 200,000
Vico: P0.40 x 300,000 lbs. 120,000
Joy: P0.40 x 800,000 lbs. 320,000
TOTAL ALLOCATED FOH P 395,500 303,000 P 514,500

3. Total costs:

PRODUCTS
ISKO VICO JOY
TOTAL ALLOCATED FOH P 395,500 P 303,000 P 514,500
Direct costs 80,000 80,000 90,000
TOTAL COSTS P 475,500 P 383,000 P 604,500

Illustration: Traditional vs. Activity-Based Costing

TEKTOK Company incurs P800,000 in manufacturing overhead costs. The company has been allocating
overhead to individual product lines based on direct labor hours.

Cost Driver Amount in Cost Pool Amount of Activity

Direct labor hours P 300,000 40,000
Number of batches 300,000 1,000
Number of shipments 200,000 500
Total overhead costs P 800,000

Two products have the following characteristics:

Product X Product Y
Direct labor hours 2,000 1,000
Number of batches 20 100
Number of shipments 2 150

Required: Determine the overhead costs to be allocated to each product using:

1. Traditional costing (based on direct labor hours)

2. Activity-based costing

ANSWERS:

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1) Traditional costing (based on direct labor hours)

Overhead application rate:

Total Factory Overhead P 800,000

÷ Total DL Hours 40,000
Overhead Application Rate P 20/DLH

FOH Allocation:

Product X Product Y
Overhead Application Rate P 20 P 20
X No. of DLH 2,000 1,000
Allocated FOH P 40,000 P 20,000

2) Activity-based costing

Pool rates:

Amount in Cost Pool Amount of Activity Pool Rates

P 300,000 40,000 DLH P 7.50/DLH
300,000 1,000 batches 300/batch
200,000 500 shipments 400/shipment
P 800,000

FOH Allocation:

Product X Product Y
Direct labor hours:
X: P7.50 x 2,000 DLH P 15,000
Y: P7.50 x 1,000 DLH P 7,500
Number of batches
X: P300 x 20 batches 6,000
Y: P300 x 100 batches 30,000
Number of shipments
X: P400 x 2 shipments 800
Y: P400 x 150 shipments 60,000
TOTAL ALLOCATED FOH P 21,800 P 97,500