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Learning Objectives


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


Understand how the choice
between allocation based on
budgeted and actual rates and
between budged and actual usage
can affect the incentives of division


Allocate multiple supportdepartment costs using the direct
method, the step-down method,
and the reciprocal method


Allocate common costs using
the stand-alone method and the
incremental method


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


Understand how bundling of
products causes revenue allocation
issues and the methods managers
use to allocate revenues

Allocation of
Costs, Common
Costs, and Revenues
How a company allocates its overhead and internal support
costs—costs related to marketing, advertising, and other internal services—among its various production departments or projects can have a big impact on how profitable those departments or projects are. While the allocation may not affect the firm’s profit as a whole, if the allocation isn’t done properly, it can make some departments and projects (and their managers) look better or worse than they should profit-wise. As the following article shows, the method of allocating costs for a project affects not just the firm but also the consumer. Based on the method used, consumers may spend more, or less, for the same service.

Cost Allocation and the Future of “Smart Grid”
Energy Infrastructure1
Across the globe, countries are adopting alternative methods of generating and distributing energy. The United States is moving toward a “Smart Grid”—that is, making transmission and power lines operate and communicate in a more effective and efficient manner using technology, computers, and software. This proposed system would also integrate with emerging clean-energy sources, such as solar farms and geothermal systems, to help create a more sustainable electricity supply that reduces carbon emissions.

Electric Power Resource Institute is an independent, nonprofit organization headquartered in California. According to this Institute, the cost of developing the “Smart Grid” is between $338 billion and $476 billion over the next two decades. These costs include new infrastructure and technology improvements—mostly to power lines—as well as costs for upgrading the power system. Private utilities and the U.S. government will pay for the costs of “Smart Grid” development, but those costs will be recouped over time by charging energy consumers. A controversy emerged as the U.S. government debated two cost allocation methods for charging consumers. One method was



Sources: Josie Garthwaite, “The $160B Question: Who Should Foot the Bill for Transmission Buildout?” (March 12, 2009); Mark Jaffe, “Cost of Smart-Grid Projects Shocks Consumer Advocates,” The Denver Post (February 14, 2010).

interconnection-wide cost allocation. Under this system, everybody in the region where a new technology was deployed would have to help pay for it. For example, if new power lines and “smart” energy meters were deployed in Denver, Colorado, everybody in Colorado would help pay for them. Supporters argued that this method would help lessen the costs of actual consumers for the significant investments in new technology. A competing proposal would allocate costs only to utility ratepayers who actually benefited from the new “Smart Grid” system. In the previous example, only utility customers in Denver would be charged for the new power lines and energy meters. Supporters of this method believed that customers with new “Smart Grid” systems should not be subsidized by those not receiving any of the benefits.

Ultimately, the government decided to only charge the consumers who benefited. These customers would see their average monthly electricity bill increase by $9 to $12, but Smart Grid technology would provide greater grid reliability, integration of solar rooftop generation and plug-in vehicles, reductions in electricity demand, and stronger cybersecurity. The same allocation dilemmas apply when costs of corporate support departments are allocated across multiple divisions or operating departments at manufacturing companies such as Nestle, service companies such as Comcast, merchandising companies such as Trader Joe’s, and academic institutions such as Auburn University. This chapter focuses on several challenges that managers face when making decisions about cost and revenue allocations.


Allocating Support Department Costs Using
the Single-Rate and Dual-Rate Methods


Companies distinguish operating departments (and operating divisions) from support departments. An operating department, also called a production department, directly adds value to a product or service. Examples are manufacturing departments where products are made. A support department, also called a service department, provides the services that assist other internal departments (operating departments and other support departments) in the company. Examples of support departments are information systems, production control, materials management, and plant maintenance. Managers face two questions when allocating the costs of a support department to operating departments or divisions: (1) Should fixed costs of support departments, such as the salary of the department manager, be allocated to operating divisions? (2) If fixed costs are allocated, should variable and fixed costs of the support department be allocated in the same way? With regard to the first question, most companies believe that fixed costs of support departments should be allocated because the support department needs to incur these fixed costs to provide operating divisions with the services they require. Depending on the answer to the first question, there are two approaches to allocating support-department costs: the single-rate cost-allocation method and the dual-rate cost-allocation method.

Distinguish the
single-rate method
. . . one rate for
allocating costs in a
cost pool
from the dual-rate
. . . two rates for
allocating costs in a
cost pool—one for
variable costs and
one for fixed costs




Single-Rate and Dual-Rate Methods
The single-rate method does not distinguish between fixed and variable costs. It allocates costs in each cost pool (support department in this section) to cost objects (operating divisions in this section) using the same rate per unit of a single allocation base. By contrast, the dual-rate method partitions the cost of each support department into two pools, a variablecost pool and a fixed-cost pool, and allocates each pool using a different cost-allocation base. 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. The latter approach is neither conceptually preferred nor widely used in practice (we explain why in the next section). Accordingly, we illustrate the single-rate and dual-rate methods next based on the use of budgeted rates. We continue the Robinson Company example first presented in Chapter 4. Recall that Robinson manufactures and installs specialized machinery for the paper-making industry. In Chapter 4 we used a single manufacturing overhead cost pool with direct manufacturing labor-hours as the cost-allocation base to allocate all manufacturing overhead costs to jobs. In this chapter, we present a more detailed accounting system to take into account the different operating and service departments within Robinson’s manufacturing department. Robinson has two operating departments—the Machining Department and the Assembly Department—where production occurs and three support departments—Plant Administration, Engineering and Production Control, and Materials Management—that provide essential services to the operating departments for manufacturing the specialized machinery.

The Plant Adminstration Department is responsible for managing all activities in the plant. That is, its costs are incurred to support, and can be considered part of the supervision costs of, all the other departments.

The Engineering and Production Control Department supports all the engineering activity in the other departments. In other words, its costs are incurred to support the engineering costs of the other departments and so can be considered part of the engineering costs of those departments.

The Materials Management Department is responsible for managing and moving materials and components required for different jobs. Each job at Robinson is different and requires small quantities of unique components to be machined and assembled. Materials Management Department costs vary with the number of material-handling labor-hours incurred to support each department. The Materials Management Department invests a substantial number of material-handling labor-hours in support of the Assembly Department.

The specialized machinery that Robinson manufactures does not go through the service departments and so the costs of the service departments must be allocated to the operating departments to determine the full cost of making the specialized machinery. Once costs are accumulated in the operating departments, they can be absorbed into the different specialized machines that Robinson manufactures. Different jobs need different amounts of machining and assembly resources. Each operating department has a different overhead cost driver to absorb overhead costs to machines produced: machine-hours in the Machining Department and assembly labor-hours in the Assembly Department. We first focus on the allocation of the Materials Management Department costs to the Machining Department and the Assembly Department. The following data relate to the 2013 budget:

Practical capacity
Fixed costs of the materials management department in the
3,000 labor-hour to 4,000 labor-hour relevant range
Budgeted usage (quantity) in labor-hours:
Machining department
Assembly department

4,000 hours

800 hours
2,800 hours
3,600 hours


Budgeted variable cost per material-handling labor-hour in
the 3,000 labor-hour to 4,000 labor-hour relevant range
Actual usage in 2013 in labor-hours:
Machining department
Assembly department

$30 per hour used
1,200 hours
2,400 hours
3,600 hours

The budgeted rates for materials management department costs can be computed based on either the demand for materials-handling services or the supply of materials-handling services. We consider the allocation of materials management department costs based first on the demand for (or usage of) materials-handling services and then on the supply of materials-handling services.

Allocation Based on the Demand for (or Usage of)
Materials-handling Services
We present the single-rate method followed by the dual-rate method. Single-Rate Method
In this method, a combined budgeted rate is used for fixed and variable costs. The rate is calculated as follows:
Budgeted usage
Budgeted total cost pool: $144,000 + 13,600 hours * $30>hour2

3,600 hours

Budgeted total rate per hour: $252,000 , 3,600 hours

$70 per hour used

Allocation rate for machining department
Allocation rate for assembly department

$70 per hour used
$70 per hour used

Note that the budgeted rate of $70 per hour is substantially higher than the $30 budgeted variable cost per hour. That’s because the $70 rate includes an allocated amount of $40 per hour (budgeted fixed costs, $144,000 , budgeted usage, $3,600 hours) for the fixed costs of operating the facility.

Under the single-rate method, departments are charged the budgeted rate for each hour of actual use of the central facility. Applying this to our example, Robinson allocates materials management department costs based on the $70 per hour budgeted rate and the actual hours the operating departments use. The support costs allocated to the two departments under this method are as follows: Machining department: $70 per hour * 1,200 hours

Assembly department: $70 per hour * 2,400 hours

$ 84,000

Dual-Rate Method
When a company uses the dual-rate method, managers must choose allocation bases for both the variable and fixed-cost pools of the materials management department. As in the single-rate method, variable costs are assigned based on the budgeted variable cost per hour of $30 for actual hours each department uses. However, fixed costs are assigned based on budgeted fixed costs per hour and the budgeted number of hours for each department. Given the budgeted usage of 800 hours for the machining department and 2,800 hours for the assembly department, the budgeted fixed-cost rate is $40 per hour 1$144,000 , 3,600 hours2, as before. Because this rate is charged on the basis of the budgeted usage, however, the fixed costs are effectively allocated in advance as a lump sum based on the relative proportions of the materials management facilities the operating departments expect to use.





The costs allocated to the machining department in 2013 under the dual-rate method would be as follows:
Fixed costs: $40 per hour * 800 (budgeted) hours
Variable costs: $30 per hour * 1,200 (actual) hours
Total costs


The costs allocated to the assembly department in 2013 would be as follows: Fixed costs: $40 per hour * 2,800 (budgeted) hours
Variable costs: $30 per hour * 2,400 (actual) hours
Total costs


Note that each operating department is charged the same amount for variable costs under the single-rate and dual-rate methods ($30 per hour multiplied by the actual hours of use). However, the overall assignment of costs differs under the two methods because the single-rate method allocates fixed costs of the support department based on actual usage of materials-handling resources by the operating departments, whereas the dual-rate method allocates fixed costs based on budgeted usage.

We next consider the alternative approach of allocating materials management department costs based on the capacity of materials-handling services supplied.

Allocation Based on the Supply of Capacity
We illustrate this approach using the 4,000 hours of practical capacity of the materials management department. The budgeted rate is then determined as follows: Budgeted fixed-cost rate per hour, $144,000 , 4,000 hours

Budgeted variable-cost rate per hour
Budgeted total-cost rate per hour

$36 per hour
30 per hour
$66 per hour

Using the same procedures for the single-rate and dual-rate methods as in the previous section, the Materials Management Department costs allocated to the operating departments are as follows: Single-Rate Method

Machining department: $66 per hour * 1,200 (actual) hours
Assembly department: $66 per hour * 2,400 (actual) hours
Fixed costs of unused materials-handling capacity:

$ 79,200

$36 per hour * 400 hoursa



400 hours = Practical capacity of 4,000 - (1,200 hours used by machining department + 2,400 hours used by assembly department).

Dual-Rate Method
Machining department
Fixed costs: $36 per hour * 800 (budgeted) hours
Variable costs: $30 per hour * 1,200 (actual) hours
Total costs
Assembly department


Fixed costs: $36 per hour * 2,800 (budgeted) hours
Variable costs: $30 per hour * 2,400 (actual) hours
Total costs
Fixed costs of unused materials-handling capacity:


$36 per hour * 400 hoursb


400 hours = Practical capacity of 4,000 hours - (800 hours budgeted to be used by machining department + 2,800 hours budgeted to be used by assembly department).


When a company uses practical capacity to allocate costs, the single-rate method allocates only the actual fixed-cost resources used by the machining and assembly departments, while the dual-rate method allocates the budgeted fixed-cost resources to be used by the operating departments. Unused materials management department resources are highlighted but usually not allocated to the departments.2

The advantage of using practical capacity to allocate costs is that it focuses management’s attention on managing unused capacity (described in Chapter 9, pages 346–347, and Chapter 12, pages 496–498). Using practical capacity also avoids burdening the user departments with the cost of unused capacity of the materials management department. In contrast, when costs are allocated on the basis of the demand for materials-handling services, all $144,000 of budgeted fixed costs, including the cost of unused capacity, are allocated to user departments. If costs are used as a basis for pricing, then charging user departments for unused capacity could result in the downward demand spiral (see page 346). Recently, the dual-rate method has been receiving more attention. Resource Consumption Accounting (RCA), an emerging management accounting system, employs an allocation procedure similar to a dual-rate system. For each cost/resource pool, cost assignment rates for fixed costs are based on practical capacity supplied, while rates for proportional costs (i.e., costs that vary with regard to the output of the resource pool) are based on planned quantities.3

There are advantages and disadvantages of using the single-rate and dual-rate methods. We discuss these next.

Advantages and Disadvantages of Single-Rate Method
Advantages (1) The single-rate method is less costly to implement because it avoids the often expensive analysis necessary to classify the individual cost items of a department into fixed and variable categories. (2) It offers user departments some operational control over the charges they bear by conditioning the final allocations on the actual usage of support services, rather than basing them solely on uncertain forecasts of expected demand.

Disadvantage The single-rate method may lead operating department managers to make sub-optimal decisions that are in their own best interest but that may be inefficient from the standpoint of the organization as a whole. This occurs because under the singlerate method, the allocated fixed costs of the support department appear as variable costs to the operating departments. Consider the setting where managers make allocations based on the demand for materials-handling services. In this case, each user department is charged $70 per hour under the single-rate method (recall that $40 of this charge relates to the allocated fixed costs of the materials management department). Suppose an external provider offers the machining department material-handling labor services at a rate of $55 per hour, at a time when the materials management department has unused capacity. The machining department’s managers would be tempted to use this vendor because it would lower the department’s costs ($55 per hour instead of the $70 per hour internal charge for materials-handling services). In the short run, however, the fixed costs of the materials management department remain unchanged in the relevant range (between 3,000 hours of usage and the practical capacity of 4,000 hours). Robinson will therefore incur an additional cost of $25 per hour if the managers were to take this offer—the difference between the $55 external purchase price and the true internal variable cost of $30 of using the materials management department.



In our example, the costs of unused capacity under the single-rate and the dual-rate methods coincide (each equals $14,400). This occurs because the total actual usage of the facility matches the total expecte...

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