CHAPTER 7
ALLOCATING COSTS OF SUPPORT DEPARTMENTS AND JOINT PRODUCTS
Allocation of support center costs is an important topic for product costing. In recent years, the issue of
accurate product costing has assumed considerable importance. Managers need to be fully aware of how
products are costed and the limitations associated with those assignments. The picture in the introduction
shows that an employee is using the copying machine in the office. This is a support department.
The chapter also addresses joint product costing. Joint production processes are common in the real
world. Oil production is an excellent example. Large amounts of money are expended to extract oil from
the ground. When the oil goes to the refinery, several different products are produced from the raw crude
oil.
LEARNING OBJECTIVES
After studying Chapter 7, students should be able to:
1. Describe the difference between support departments and producing departments.
2. Calculate charging rates, and distinguish between single and dual charging rates.
3. Allocate support center costs to producing departments using the direct method, the sequential
method, and the reciprocal method.
4. Calculate departmental overhead rates.
5. Identify the characteristics of the joint production process, and allocate joint costs to products.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. An Overview of Cost Allocation (LO 1)
2. Allocating One Department’s Costs to Other Departments (LO 2)
3. Choosing a Support Department Cost Allocation Method (LO 3)
4. Departmental Overhead Rates and Product Costing (LO 4)
5. Accounting for Joint Production Processes (LO 5)
I. AN OVERVIEW OF COST ALLOCATION
A. Types of Departments
In earlier chapters, we discussed factory overhead allocation. That discussion was simplified by the fact
that factory overhead costs in a producing department were always a given amount. Chapter 7 asks us to
step back and trace these factory overhead costs from incurrence through assignment to the units
produced during the period.
Producing departments are units within an organization that are directly responsible for creating the
products and services sold to customers. Examples of producing departments for manufacturing
companies include cutting, assembly, and finishing. Examples of producing departments for an
accounting firm (a service company) include auditing, tax, and management advisory services.
Support departments are units within an organization that provide essential support services for producing
departments. Some examples of support departments include maintenance, grounds, engineering,
housekeeping, personnel, and stores.
Exhibit 7.1 (p. 314) shows how a manufacturing firm and a service firm can be divided into producing
and support departments.
Exhibit 7.2 (p. 315) provides the steps required to allocate support department costs to a producing
department.
1. Departmentalize the firm.
2. Classify each department as a support department or a producing department.
3. Trace all overhead costs in the firm to a support or producing department.
4. Allocate support department costs to the producing departments.
5. Calculate predetermined overhead rates for producing departments.
6. Allocate overhead costs to the units of individual product through the predetermined overhead
rates.
Support costs should be allocated using factors that explain or relate to the consumption of the services.
Some examples of activity drivers for support departments are listed below.
Support Department
Possible Activity Driver
Cafeteria
Number of employees
Engineering
Number of change orders
Maintenance
Machine hours
Payroll
Number of employees
Personnel
Number of new hires
Teaching hint: Use the opening scenario in the chapter to introduce the concept of the two categories of
departments: producing departments and support departments. Each type of department should be
defined, and it should be indicated that this chapter is primarily concerned with describing ways of
allocating support department costs to producing departments.
B. Objectives of Allocation
The following major objectives of allocating support department costs have been identified by the IMA:
1. To obtain a mutually agreeable price.
2. To compute product-line profitability.
3. To predict the economic effects of planning and control.
4. To value inventory.
5. To motivate managers.
Several guidelines exist to help determine the best allocation method, including cause and effect, benefits
received, fairness, and ability to bear.
Although it may not be possible to identify a method of allocating support department costs that satisfies
all the objectives of allocation, the fundamental principles noted above should be followed in allocating
support costs.
Teaching hint: It would be helpful to tell students that there should be a strong relationship between the
cost pool and the cost driver. If we have a change in the cost driver, we should see a predictable change in
the cost pool.
II. ALLOCATING ONE DEPARTMENT’S COSTS TO OTHER DEPARTMENTS
In determining an appropriate charging rate to assign support department costs to producing departments,
two major factors should be considered:
1. The choice of a single or a dual charging rate.
2. The use of budgeted versus actual support department costs.
When using a single charging rate, variable and fixed costs are allocated from support departments to
producing departments using a single rate. Dual charging rates utilize one rate for allocating fixed costs
and another rate for allocating variable costs. Cornerstone 7.1 (p. 318) illustrates the calculation and use
of the single charging rate when it is applied to budgeted amounts.
When using dual charging rates, the company determines at the beginning of the year what the variable
cost per unit of service should be. Here, a budgeted rate, not an actual rate, is used to assign variable
costs. Each producing department must determine its expected or budgeted usage of the service for the
year.
Variable support costs are allocated by multiplying the budgeted rate by the usage. For product costing,
the allocation amount equals the budgeted rate multiplied by the budgeted usage. For purposes of
performance evaluation, the allocation amount equals the budgeted rate multiplied by the actual usage.
For the allocation of fixed costs, the fixed support service costs that should be incurred for a period need
to be identified. Using either practical or normal capacity of each producing department, an allocation
ratio is computed as follows:
Allocation ratio = Production department capacity/Total capacity
The fixed support costs are allocated in proportion to each producing department’s original support
service needs. The allocation is as follows:
Allocation = Allocation ratio × Budgeted fixed support service costs
Fixed costs are allocated the same way for both product costing and performance evaluation. Cornerstone
7.2 (p. 321) helps illustrate these concepts. Also, Exercise 7.17 is a good problem to use in class to
illustrate the dual rates.
III. CHOOSING A SUPPORT DEPARTMENT COST ALLOCATION METHOD
There are three methods commonly used to allocate support costs: (1) the direct method, (2) the
sequential (or step) method, and (3) the reciprocal method. It is important for students to realize that total
factory overhead costs remain unchanged despite the method used to allocate support department costs.
The three allocation methods simply allocate the total costs differently among the producing departments.
Teaching hint: Encourage students to sum the direct overhead costs of the producing and support
departments prior to allocation and then sum the overhead costs of the producing departments after
allocation. The two sums should be identical (barring rounding errors).
The direct method assumes no interactions between the support departments. Therefore, support
department costs are allocated only to producing departments, never to other support departments.
The sequential (or step) method recognizes that interactions among the support departments do occur but
assumes that they occur in a sequential manner, where the sequence is assumed to follow the degree of
support rendered. This method assumes one-way relationships between the support departments (i.e.,
Department A provides services to Department B, but Department B does not provide services to
Department A).
Exhibits 7.7 (p. 327) and 7.8 (p. 330) provide excellent diagrams to illustrate the cost allocation approach
of these two methods.
The reciprocal method provides the most complete approach to dealing with support department
interactions. This method assumes two-way relationships between the support departments. For example,
the Personnel Department uses the services of the Maintenance Department and the Maintenance
Department uses the services of the Personnel Department. What is the total cost associated with the
Personnel Department? It would be the Personnel Department’s direct costs plus the cost of cleaning the
Personnel Department’s office that is “hidden” in the direct costs of the Maintenance Department.
Determining the degree to which the two departments increase each other’s costs can be determined only
by solving a system of simultaneous equations.
Cornerstones 7.3 (p. 328), 7.4 (p. 331), and 7.5 (p. 333) show how to allocate support department costs to
producing departments using these three methods, respectively. In addition, Exercises 7.20, 7.21, and 7.22
are good examples to use to illustrate the three allocation methods.
IV. DEPARTMENTAL OVERHEAD RATES AND PRODUCT COSTING
Once all of the costs have been allocated from the support departments to the producing departments, an
overhead rate can be calculated for each of the production departments. This rate is computed by adding
the allocated service costs to the overhead costs that are directly traceable to the producing department
and dividing this total by some measure of activity, such as direct labor hours or machine hours.
Cornerstone 7.6 (p. 336) shows how to use the allocated support department costs to calculate
departmental overhead rates. Requirement 2 of Exercises 7.20, 7.21, and 7.22 requires the calculation of
departmental overhead rates.
V. ACCOUNTING FOR JOINT PRODUCTION PROCESSES
A. Overview
Joint products are two or more products produced simultaneously by the same process up to a “split–off”
point. The split-off point is the point at which the joint products become separate and identifiable. Exhibit
7.10 (p. 339) shows a diagram of a joint production process. Exhibit 7.11 (p. 339) illustrates an
independent multiple-product production using the same material.
Separable costs are easily traced to individual products and offer no particular problem. If costs are not
separable, they must be arbitrarily allocated to products.
B. Accounting for Joint Product Costs
The difficulty in accounting for joint costs centers on how to best allocate those costs to products. An
allocation method must be found that allocates costs on as reasonable a basis as possible. Because
judgment is involved, different costs can be calculated for the same products—all due to the allocation
method selected for the joint product costs.
The following methods are discussed:
1. Physical units method
2. Weighted average method
3. Sales-value-at-split-off method
4. Net realizable value method
5. Constant gross margin percentage method
Under the physical units method, joint costs are distributed to products on the basis of some physical
measure. Cornerstone 7.7 (p. 341) is a good numerical example to use to display this method.
The weighted average method builds on the physical units method and assigns a weight factor.
Cornerstone 7.8 (p. 343) shows how the weighted average method can be used to allocate joint costs to
different products. Exercise 7.25 is useful to demonstrate the weighted average method and physical units
method.
Other methods rely more on relative market values to allocate joint costs. The sales-value-at-split-off
method allocates joint cost based on each product’s proportionate share of market or sales value at the
split-off point. Cornerstone 7.9 (p. 345) shows how to allocate joint costs using the sales-value-at-split-off
method. Exercise 7.26 can be used to illustrate the concept. This exercise builds on the information
provided in Exercise 7.25.
The net realizable value method can be used when there is no ready market for intermediate products.
First, a hypothetical sales value is calculated. Then, joint costs can be allocated based on each product’s
share of this value. Cornerstone 7.10 (p. 347) shows how to use the net realizable value method to
allocate joint costs. Exercise 7.27 can be used to demonstrate this method. This exercise also addresses
the decision to sell at split-off or process further.
The final method presented is the constant gross margin percentage method. Here, joint costs are
allocated so that the gross margin is the same for each product. Cornerstone 7.11 (p. 348) is a good
example to illustrate this method.
C. Distinction and Similarity between Joint Products and By-Products
The primary purpose of by-product and joint cost accounting is to determine income and inventory
amounts for financial reporting purposes. The distinction between joint products and by-products rests
solely on the relative importance of their sales value.
A by-product is a secondary product recovered in the course of manufacturing a primary product. The
market value of a by-product is relatively minor in comparison with that of a primary product. Many
times a by-product is an output of a joint production process. If the income generated by the by-product is
credited to an income account, the revenue from the by-product will appear in the “Other Income” section
of the income statement. No costs are matched against the revenue from the by-product.
Instead of treating the by-product as other income, the revenue generated by the by-product could be
treated as a reduction of the manufacturing costs of the main products. This approach is similar to the
accounting treatment for the disposal of waste or scrap.
D. Effect of Joint Product Costs on Cost Control and Decision Making
It is important to understand when the use of allocated joint product costs may be misleading. In making
decisions relative to jointly produced products, students should remember that the products are
necessarily produced jointly. Some areas that can be affected by joint cost allocations are output
decisions, further processing of joint products, and pricing jointly produced products. When making a
decision to sell a joint product at split–off or to process the product further, only costs and revenues
incurred after the split-off point should be considered. Allocated joint costs are irrelevant for this type of
decision.
VI. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described below and on the following two pages according to coverage of
content, learning objective(s), and level of difficulty. The time required to solve the problems is roughly
proportional to the level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Degree of
Difficulty
CS 7.1
Calculating and Using a Single Charging Rate
Basic
CS 7.2
Calculating and Using Dual Charging Rates
Basic
CS 7.3
Direct Method of Support Department Cost Allocation
Basic
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Degree of
Difficulty
CS 7.4
Sequential (Step) Method of Support Department Cost
Allocation
Basic
CS 7.5
Reciprocal Method of Support Department Cost
Allocation
Basic
CS 7.6
Calculating Departmental Overhead Rates Using Post-
Allocation Costs
Basic
CS 7.7
Allocating Joint Costs Using the Physical Units
Method
Basic
CS 7.8
Allocating Joint Costs Using the Weighted Average
Method
Basic
CS 7.9
Allocating Joint Costs Using the Sales-Value-at-Split-
Off Method
Basic
CS 7.10
Allocating Joint Costs Using the Net Realizable Value
Method
Basic
CS 7.11
Allocating Joint Costs Using the Constant Gross
Margin Method
Basic
7.12
Classifying Departments as Producing or Support—
Manufacturing Firm
Basic
7.13
Classifying Departments as Producing or Support—
Service Firm
Basic
7.14
Identifying Casual Factors for Support Department
Cost Allocation
Basic
7.15
Objectives of Cost Allocation
Basic
7.16
Objectives of Allocation
Basic
7.17
Single and Dual Charging Rates
Moderate
7.18
Actual versus Budgeted Costs
Moderate
7.19
Fixed and Variable Cost Allocation
Moderate
7.20
Direct Method and Overhead Rates
Basic
7.21
Sequential Method
Basic
7.22
Reciprocal Method
Moderate
7.23
Direct Method
Basic
7.24
Sequential Method
Basic
7.25
Physical Units Method
Basic
7.26
Sales-Value-at-Split-Off Method
Basic
7.27
Net Realizable Value Method, Decision to Sell at Split-
Off or Process Further
Basic
7.28
CPA-Type Exercise
Basic
7.29
CPA-Type Exercise
Basic
7.30
CPA-Type Exercise
Basic
7.31
CPA-Type Exercise
Basic
7.32
CPA-Type Exercise
Basic
7.33
Allocation: Fixed and Variable Costs, Budgeted Fixed
and Variable Costs
Moderate
7.34
Direct Method, Variable versus Fixed Costing and
Performance Evaluation
Moderate
7.35
Comparison of Methods of Allocation
Moderate
7.36
Direct Method, Reciprocal Method, Overhead Rates
Moderate
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Degree of
Difficulty
7.37
Physical Units Method, Relative Sales Value Method
Moderate
7.38
Fixed and Variable Cost Allocation
Moderate
7.39
Physical Units Method, Relative Sales-Value-at-Split-
Off Method, Net Realizable Value Method, Decision
Making
Challenging
7.40
Single Charging Rates
Moderate
7.41
Cyber Research Case
Challenging
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 7.1
Examples of Departmentalization for a Manufacturing Firm and a Service Firm
Exhibit 7.2
Steps in Allocating Support Department Costs to Producing Departments
Exhibit 7.3
Examples of Possible Activity Drivers for Support Departments
Exhibit 7.4
Use of Budgeted Data for Product Costing: Comparison of Single- and Dual-Rate
Methods
Exhibit 7.5
Use of Actual Data for Performance Evaluation Purposes: Comparison of Single- and
Dual-Rate Methods
Exhibit 7.6
Data for Support and Producing Departments
Exhibit 7.7
Allocation of Support Department Costs to Producing Departments Using the Direct
Method
Exhibit 7.8
Allocation of Support Department Costs to Producing Departments Using the
Sequential Method
Exhibit 7.9
Comparison of Support Department Cost Allocations Using the Direct, Sequential, and
Reciprocal Methods
Exhibit 7.10
Joint Production Process
Exhibit 7.11
Independent Multiple-Product Production Using the Same Material