Week 4

Week 4
1
Allocation of
Support-Department Costs,
Common Costs,
and Revenues
ORS - http://www.dailymotion.com/video/x1ql7m9_ors-group-business-process-
outsourcing-explained_tech
XEROX - http://www.services.xerox.com/business-process-outsourcing/enus.html
https://www.youtube.com/watch?v=DCOQqvBFV_A

Lesson Plan
 Presentations
 Youtube video – comments –
 SIGN UP FOR Google Account
 Chptr 15 SD Costs
 Feedback on Tables
2

3
Week 4: Learning objective summary
 Service cost allocation basis
 Why are service dept cost allocations important?
 What are service departments
 Reasons for allocating service department costs
 Pitfalls to avoid
 Single vs. Dual rate method
 Learning objective 1: Distinguish the single-rate method from the dual-rate method
 Budgeted vs. Actual cost allocation
 Learning objective 2: Understand how the choice between allocation based on budgeted and actual rates
and between budgeted and actual usage can affect the incentives of division managers
 Direct / Step-down method
 Learning objective 3: Allocation support-department costs using the direct method, the step-down method
and the reciprocal method
 Other cost allocation issues
 Learning objective 4: Allocate common costs using the stand-alone method and the incremental method
 Learning objective 5: Explain the importance of explicit agreement between contracting parties when the
reimbursement amount is based on costs incurred
 Learning objective 6: Understand how bundling of products causes revenue-allocation issues and the
methods managers use to allocate revenues
Other cost allocation issues
Service cost allocation basis
Budgeted/ Actual cost
allcoationSingle/Dual rate method Direct/ Step-down method

Videos
 HKU – Xerox Website
 https://www.youtube.com/watch?v=HO5Uy26
VgQ0&index=21&list=PL64E49EE5F8646716
 Tale of two factories
 PQI
4

Doing Business with China and Chinese suppliers | 5
Tale of Two Factories

Operating
Department
(Machining)
Operating
Department
(Assembly)
The
Products
Service
Department
(Cafeteria)
Service
Department
(Accounting)
Service
Department
(Personnel)
The big picture
OVERHEAD
- Pricing
- Value
engineering
Operating
Dept
Overhead
-Planning
(resource, capacity)
- Control (efficiency,
performance
evaluation)
-Planning
(resources, capacity)
performance
evaluation)
Service Dept O/H
http://www.realbusiness.com/?c
mp=xrb001#/ready-for-business
https://www.youtube.com/watch
?v=DCOQqvBFV_A
http://www.services.xerox.com/b
usiness-process-
outsourcing/enus.html
6

10
Why? – Business Process Outsourcing
10
Other cost allocation issuesService cost allocation
basis
allocationSingle/Dual rate method Direct/ Step-down method
ORS - http://www.dailymotion.com/video/x1ql7m9_ors-group-business-process-
outsourcing-explained_tech
XEROX - http://www.services.xerox.com/business-process-outsourcing/enus.html
https://www.youtube.com/watch?v=DCOQqvBFV_A

11
Why? - Real World #1
(source: CIO – Mar 1, 2003)
11
Richard Scannell – Senior IT Manager – Motorola
Chargeback at Motorola was based on headcount. That works in
theory, says Scannell, but in practice quickly turns sour.
"If the electric company turned around and said,
There's 2,000 people in your town, and we're
going to divide the town's usage by 2,000 and
charge each of you a two-hundredth of the total,
then you'd likely object," he says. "If it doesn't
work with power, why should it work with IT?"
basis

12
12
Nordin, vice president and CIO of specialty metals manufacturer
A.M. Castle
“…it's way too much work..[to allocate every $IT
to producing depts.]. It's a never-ending debate
over what constitutes a fair share. In the end, it
comes down to this: What am I being paid to do?
And I think I'm being paid to do more that just
debate MIPS and CPU cycles."
basis

13
13
Business applications, on the other hand, reside at the center on a number
of servers and are not charged out. "We tend to bring that sort
of expense up to the top, and call it IT Budget,"
basis

14
14
Keith Kaczanowski, vice president of process improvement at Brady Corp. of
Milwaukee, a manufacturer of signs, labels and associated printing equipment.
"If all you do is reshuffle costs within the company,
then chargeback probably isn't worth it," he says.
"But if you think that people will make better
decisions by being forced to confront the cost,
then there is value.
basis

What are service departments?
Examples of Departmentalization
15
basis
http://www.services.xerox.com
/business-process-
outsourcing/enus.html

16
Week 4: Learning objective summary
A
Learning objective A:
Understand the
reasons for allocating
service dept costs and
the pitfalls to avoid

Once service department cost
allocations are completed, they are
included in operating departments’:
Performance
evaluations
Profitability
determination
Overhead rate
computations
17
Why? - Effect of allocations on operating
departments
basis
P R D

18
Reasons for allocating service department costs
To encourage operating
departments to wisely
use service department
resources.
To provide operating
departments with more
complete cost data
for making decisions.
To help measure the
profitability of operating
departments.
To create incentive
for service departments
to operate efficiently.
To value inventory for
external financial
reporting purposes.
To include all overhead
in the cost base when
cost-plus pricing is used.
P
P
D
R
R D
basis

First Stage Allocations
Service department costs are allocated
to operating departments.Service
Department
(Cafeteria)
Service
Department
(Accounting)
Service
Department
(Personnel)
Operating
Department
(Machining)
Operating
Department
(Assembly)
The
Products
19
Effect of allocations on operating departments
basis

Service
Department
(Cafeteria)
Service
Department
(Accounting)
Service
Department
(Personnel)
Operating
Department
(Machining)
Operating
Department
(Assembly)
The
Products
Second Stage Allocations
Operating department overhead costs and allocated
service department costs are applied to products.
20
Effect of allocations on operating departments
basis

Operating
Department
(Machining)
Operating
Department
(Assembly)
The
Products
Service
Department
(Cafeteria)
Service
Department
(Accounting)
Service
Department
(Personnel)
21
The big picture
OVERHEAD
- Pricing
- Value
engineering
Operating
Dept
Overhead
-Planning
(resource, capacity)
performance
evaluation)
-Planning
(resources, capacity)
performance
evaluation)
Service Dept O/H
21

22
In practice - benefits received and cause-effect are widely used
for a couple of reasons:
 Fairness or equity is difficult to agree on
 Ability to bear criterion raises issues related to cross- subsidization across users
of resources in an organization.
Thus you could argue that there are three types:
 benefits/cause and effect,
 fairness
 ability to bear
Recall - Basis of cost allocation?
22
basis

23
Examples of Allocation Bases
Exh.
15-1
Service Department Allocation Bases
Laundry Square footage occupied
Airport Ground Services Cases handled; number of employees;
Cafeteria hours worked
Medical Facilities Labor hours; customers served
Materials Handling Number of personal computers;
applications installed
Information Technology Hours of service; volume handled
Number of meals
Custodial Services KWH used; capacity of machines
Cost Accounting Units handled; number of requisitions;
Power space occupied
Human Resources Number of flights
Receiving, Shipping, and Stores Number of employees; training hours
Pounds of laundry
Factory Administration Machine hours
basis

24
Examples of Allocation Bases
Service Department Allocation Bases
Laundry Pounds of laundry
Airport Ground Services Number of flights
Cafeteria Number of meals
Medical Facilities Cases handled; number of employees;
hours worked
Materials Handling Hours of service; volume handled
Information Technology Number of personal computers;
applications installed
Custodial Services Square footage occupied
Cost Accounting Labor hours; customers served
Power KWH used; capacity of machines
Human Resources Number of employees; training hours
Receiving, Shipping, and Stores Units handled; number of requisitions;
space occupied
Factory Administration Total labor hours
Exh.
15-1
basis

25
Allocation pitfalls to avoid
Pitfall: Allocating fixed
costs using a variable
allocation base
Result: Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.

Methods to Allocate
Support Department Costs
 Single-rate method – one rate for allocating costs in a cost pool
 simple to implement, but treats fixed costs in a manner similar to variable costs
 Dual-Rate method – segregates costs within each cost pool into
two segments: a variable-cost pool and a fixed-cost pool.
 Each pool uses a different cost-allocation base
 treats fixed and variable costs more realistically, but is more complex to
implement
 When possible, variable and fixed service department costs should be allocated
separately.
 Variable service department costs should be allocated to consuming
departments according to the activity causing incurrence of the cost.
Learning objective 1:
Distinguish the
single-rate method
…one rate for
allocating costs in a
cost pool
From the dual-rate
method
… two rates for
allocating costs in a
cost pool-one for
variable costs and
one for fixed costs
1
26

Learning Objective 1
Single Dual
Budget Rate
(decision-making)
Fairness / Controllability
Capacity Planning
Decision Making
Actual Rate
(performance
evaluation)
Relevant Costs
Efficiency
Accuracy
Support Department Cost Allocation - choice of rates
27
LearningObjective2

1. Single/Dual rate method
 Single rate (versus nothing)
 Benefits
1. Control service (indirectly – the user dept might complain about the service if
they are being charged)
 Dual rate (versus single rate)
 Benefits
1. Control service (indirectly – the user dept might complain about the service if
they are being charged)
2. Signal relevant costs to user dept for decision making (assuming users
can go elsewhere)
 Example 1 – Sand Hill company
28

Example 1: Sand Hill Company
Assume Fixed costs are assigned on basis of budgeted usage
Central Computer Department of Sand Hill Company (SHC) has two users, both operating
divisions: the Microcomputer Division and the Peripheral Equipment Division. The following
data related to the 2009 budget:
Practical capacity 18,750 hours
Fixed costs of operating the computer facility in the 6,000-hour to
18,750-hour relevant range ($160 - $500 per hour)
$3,000,000
Budgeted long-run usage (quantity) in hours ($250 per hour):
Microcomputer Division 8,000 hours
Peripheral Equipment Division 4,000 hours
Total 12,000 hours
Budgeted variable cost per hour in the 6,000-hour to 18,750-hour
relevant range
$200 per hour used
Actual usage in 2009 in hours:
Total 12,000 hours
29

SINGLE RATE VS DUAL RATE
INSIDE
SERVICE
$450 USER
dept
OUTSIDE
SERVICE
$250
$250 WHO LOSES?
30

SINGLE RATE VS DUAL RATE
INSIDE
$200
Variable
USER
dept
OUTSIDE
$250
$250
FIXED
$250
FIXED
31

Benefits - Assume Fixed costs are assigned on basis of budgeted usage
1. Decision – service efficiency – user dept’s become customers -
- Control service put pressure on service dept to provide value
for money!!
2. Decision – Signal relevant costs to user dept
A. Single rate method  User dept’s might incorrectly view the variable
cost as a relevant cost and seek cheaper services outside – anywhere
between $200 and $450 per hour
- $200 (VC) ---------------$450 (TC) per hour
B. Dual rate method  User dept’s see the relevant costs for alternative
supply assessment (ie cause & effect)
- $200 (VC) Plus FIXED COSTS
32

Allocation based on the Demand for (or Usage of ) computer services
Single-rate method
Budgeted usage 12,000 hours
Budgeted total cost pool: $3,000,000 + (12,000hours * $200/hour) $5,400,000
Budgeted total rate per hour: $5,400,000 / 12,000 hours $450 per hour used
Allocation rate for Microcomputer Division $450 per hour used
Allocation rate for Peripheral Equipment Division $450 per hour used
The support cost allocated to the two divisions under single-rate method:
Microcomputer Division: 9,000 hours * $450 per hour $4,050,000
Peripheral Equipment Division: 3,000 hours* $450 per hour $1,350,000
33

Allocation based on the Demand for (or Usage of ) computer services
Dual-rate method
Given the budgeted usage of 8,000 hours for the Microcomputer Division and 4,000 hours
for the Peripheral Equipment Division, the budgeted fixed-cost rate is $250 per hour
($3,000,000 / 12,000 hours).
The costs allocated to the Microcomputer Division in 2009:
The cost allocated to the Peripheral Equipment Division in 2009:
Fixed costs: $250 per hour * 8,000 (budgeted ) hours $2,000,000
Variable costs: $200 per hour * 9,000 (actual) hours 1,800,000
Total costs $3,800,000
Fixed costs: $250 per hour * 4,000 (budgeted ) hours $1,000,000
Variable costs: $200 per hour * 3,000 (actual) hours 600,000
34

Allocation Bases
 Under either method, allocation of support costs can be based on
one of the three following scenarios:
1. Budgeted overhead rate and budgeted hours
2. Budgeted overhead rate and actual hours
3. Actual overhead rate and actual hours
 Choosing between actual and budgeted rates: budgeted is known
at the beginning of the period, while actual will not be known with
certainty until the end of the period
Understand how the choice between
allocation based on budgeted and actual
rates
…budgeted rates provide certainty to users
about charges and motivate the support
division to engage in cost control
And between budgeted and actual usage
can affect the incentives of division
managers
---budgeted usage helps in planning and
efficient utilization of fixed resources;
actual usage controls consumption of
variable resouces
2
35

2. Budgeted/Actual cost allocation (fixed costs only)
 Budget/Actual cost allocation rates
 Benefits
1. Control service (indirectly – the user dept might complain about the
service if they are being charged)
2. Signal relevant costs to user dept for decision making (assuming
users can go elsewhere)
3. Control user efficiency (directly – actual rate)
 Actual rates leave costs associated with inefficiencies in the service dept’s but
create incentives for user dept’s to be more efficient (and only use the amount of
service that they need).
 We have a problem whereby a user dept may use the same amount of resources
but get charged more.
4. Controlling capacity – who should be responsible for excess
capacity?
 Example 2 – Sand Hill company
36

Central Computer Department of Sand Hill Company (SHC) has two users, both operating
divisions: the Microcomputer Division and the Peripheral Equipment Division. The following
data related to the 2009 budget:
Practical capacity 18,750 hours
Fixed costs of operating the computer facility in the 6,000-hour to
18,750-hour relevant range
$3,000,000
Budgeted long-run usage (quantity) in hours:
Total 12,000 hours
Budgeted variable cost per hour in the 6,000-hour to 18,750-hour
relevant range
$200 per hour used
Actual usage in 2009 in hours:
Total 12,000 hours
37

Example 2: Sand Hill Company Comparative Allocation Bases
Compare 1, 2 and 3:
Budget rates provide certainty
for capacity planning
Compare 1 with 2 or 3:
Actual rates provide incentives
for efficient use of services
Based on $3 Million / 18,750 hours
- provide incentives for service division to
efficiency plan for capacity
38

4. Controlling capacity who should be responsible for excess capacity?
Budget capacity – fixed rate = $250 per hour (12,000 hours)
Practical capacity – fixed rate = $160 per hour (18,750 hours)
18,750 hours – 12,000 hours = 6,750 hours * $160 = $1,080,000)
If Actual usage (10,000) <
budget (12,000) – then
allocate to user dept (make
user dept responsible!)
If Actual usage (12,000) = budget
(12,000) < practical capacity (18,750)
– then ask service dept why they have
unused capacity (6,750 hours) (make
the service dept responsible) 39

Allocation based on the Supply of Capacity
Using 18,750 hours of practical capacity of the Central Computer Department, the budgeted
rate is as follows:
Microcomputer Division: $360 per hour * 9,000 (actual) hours $3,240,000
Peripheral Equipment Division: $360 per hour * 3,000 (actual) hours 1,080,000
Fixed costs of unused computer capacity:
$160 per hour * 6,750 hours
$1,080,000
Budgeted fixed-cost rate per hour, $3,000,000 / 18,750 hours $160 per hour
Budgeted variable-cost rate per hour 200 per hour
Budgeted total-cost rate per hour 360 per hour
Single-rate method
6,750 hours = Practical capacity of 18,750 – ( 9,000 hours used by Microcomputer Division + 3,000
hours used by Peripheral Equipment Division)
Be careful -
Confusing
Recall – Example 2 - $160 per hour is based on $3
Million / 18,750 hours - provide incentives for service division
to efficiency plan for capacity – should plan for 12,000 hours
40

Allocation based on the Supply of Capacity
Microcomputer Division
Fixed costs: $160 per hour * 8,000 (budgeted) hours $1,280,000
Variable cost: $200 per hour * 9,000 (actual) hours 1,800,000
Peripheral Equipment Division
Fixed costs: $160 per hour * 4,000 (budgeted) hours $ 640,000
Variable cost: $200 per hour * 3,000 (actual) hours 600,000
Fixed costs of unused computer capacity:
$160 per hour * 6,750 hours
$1,080,000
Dual-rate method
6,750 hours = Practical capacity of 18,750 – ( 8,000 hours budgeted to be used by Microcomputer
Division + 4,000 hours budgeted to be used by Peripheral Equipment Division)
Be careful -
Confusing
41

2. Budgeted/Actual cost allocation (fixed costs only)
 Benefits
1. Control service (indirectly – the user dept might complain about the
service if they are being charged)
2. Signal relevant costs to user dept for decision making (assuming
users can go elsewhere)
3. Control user efficiency (directly – actual rate)
 Actual rates leave costs associated with inefficiencies in the service dept’s but
create incentives for user dept’s to be more efficient (and only use the amount of
service that they need).
 We have a problem whereby a user dept may use the same amount of resources
but get charged more.
4. Controlling capacity – who should be responsible for excess
capacity?
42

43
Quiz 1:
Allocating costs by behavior
Foster City has an ambulance service that is used by the two public
hospitals in the city. Variable ambulance costs are budgeted at $4.20 per
mile. Fixed ambulance costs are budgeted at $120,000 per year. Data
relating to the current year are:
Percent of
Peak-Period
Capacity Miles Miles
Hospitals Required Planned Used
Mercy 45% 15,000 16,000
Northside 55% 17,000 17,500
Total 100% 32,000 33,500

44
Quiz 1
How much ambulance service cost will be allocated to Mercy
Hospital at the beginning of the year?
a. $117,000
b. $254,400
c. $114,480
d. $119,250

45
Quiz 1
Hospital at the beginning of the year?
a. $117,000
b. $254,400
c. $114,480
d. $119,250

46
Quiz 1
Hospital at the end of the year?
a. $114,000
b. $118,800
c. $110,400
d. $121,200

47
Quiz 1
Hospital at the end of the year?
a. $114,000
b. $118,800
c. $110,400
d. $121,200

Methods of Allocating Support Costs to
Production Departments
1. Direct
2. Step-Down
3. Reciprocal
allocationSingle/Dual rate method
Direct/ Step-down
method
Allocation multiple support-department costs using the direct
method,
…allocate support-department costs directly to operating
departments
The step-down method,
…partially allocates support-department costs to other support
departments
And the reciprocal method
…fully allocates support-department costs to other support
departments
3
48

49
Interdepartmental services
Problem
Allocating costs
when service
departments
provide services
to each other
Solutions
Direct Method
Step Method
Reciprocal Method
Direct/ Step-down
method

Direct Method
Manufacturing
Information Systems
Accounting
Packaging
Support Departments Production Departments
• Allocates support costs only to Operating Departments
• No Interaction between Support Departments prior to allocation
Direct/ Step-down
method
50

51
Direct Method
Service
Department
(Cafeteria)
Service
Department
(Custodial)
Operating
Department
(Machining)
Operating
Department
(Assembly)
Interactions
between service
departments are
ignored and all
costs are
allocated directly
to operating
departments.
Direct/ Step-down
method

Example 3: Castleford Engineering
Data Used in Cost Allocation Illustrations
Direct/ Step-down
method
52

Example 3: Castleford Engineering
Direct Allocation Method Illustrated
Direct/ Step-down
method
53

Operating
Department
(Machining)
Operating
Department
(Assembly)
54
Step-Down Method
Once a service
department’s costs
are allocated,
other service
department costs
are not allocated
back to it.
Service
Department
(Cafeteria)
Service
Department
(Custodial)
Direct/ Step-down
method

55
There are three key points to understand regarding
the step-down method:
 In both the direct and step methods, any amount of
the allocation base attributable to the service
department whose cost is being allocated is always
ignored.
 Any amount of the allocation base that is
attributable to a service department whose cost has
already been allocated is ignored.
 Each service department assigns its own costs to
operating departments plus the costs that have
been allocated to it from other service departments.
Step-Down Method
Direct/ Step-down
method

Step-Down Method
Manufacturing
Information Systems
Accounting
Packaging
Support Departments Production Departments
Direct/ Step-down
method
56

Example 3 : Castleford Engineering
Step-Down Allocation Method
Direct/ Step-down
method
57

Example 3 : Castleford Engineering
Step-Down Allocation Method
Direct/ Step-down
method
58

61
Quiz 2: Data for Direct and Step Methods
The direct method of allocation is used.
Allocation bases:
Business school administration costs (ADMIN):
Number of employees
Business Administration computer services (BACS):
Number of personal computers
Direct/ Step-down
method

62
Quiz 2
How much cost will be allocated from Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
Direct/ Step-down
method

63
$180,000 ×
20
20 + 80
= $36,000
How much cost will be allocated from Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
Quiz 2
Direct/ Step-down
method

64
How much total cost will be allocated from ADMIN and BACS combined to
the Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
Quiz 2
Direct/ Step-down
method

65
How much total cost will be allocated from ADMIN and BACS combined to
the Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
$90,000 ×
18
18 + 102
= $13,500
Quiz 2
Direct/ Step-down
method

66
How much total cost will be allocated from ADMIN and BACS
combined to the Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
Quiz 2
Direct/ Step-down
method

67
How much total cost will be allocated from ADMIN and BACS
combined to the Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
Quiz 2
Direct/ Step-down
method

Allocating Common Costs
 Common Cost – the cost of operating a facility, activity, or like cost
object that is shared by two or more users at a lower cost than the
individual cost of the activity to each user
Allocate common costs using the stand-
alone method
…uses cost information of each user as a
separate entity to allocated common costs
And the incremental method
…allocates common costs primarily to one
user and the remainder to other users
4
68

Methods of Allocating Common Costs
 Stand-Alone Cost-Allocation Method – uses information pertaining
to each user of a cost object as a separate entity to determine the
cost-allocation weights
 Individual costs are added together and allocation percentages are
calculated from the whole, and applied to the common cost
69

Methods of Allocating Common Costs
 Incremental Cost-Allocation Method ranks the individual users of a
cost object in the order of users most responsible for a common cost
and then uses this ranking to allocate the cost among the users
 The first ranked user is the Primary User and is allocated costs up the
cost as a stand-alone user (typically gets the highest allocation of the
common costs)
 The second ranked user is the First Incremental User and is allocated
the additional cost that arises from two users rather than one
 Subsequent users handled in the same manner as the second ranked
user
70

Cost Allocations and Contracting
 The US government reimburses most contractors in either of two
main ways:
1. The contractor is paid a set price without analysis of actual contract
cost data.
2. The contractor is paid after an analysis of actual contract cost data.
In some cases, the contract will state that the reimbursement amount
is based on actual allowable costs plus a fixed fee (cost-plus contract)
Explain the importance of explicit
agreement between contracting parties
when the reimbursement amount is based
on costs incurred
…to avoid disputes regarding allowable
cost items and how indirect cost should be
allocated
5
71

Revenue Allocation and Bundled Products
 Revenue Allocation occurs when revenues are related to a particular
revenue object but cannot be traced to it in an economically feasible
manner
 Revenue Object – anything for which a separate measurement of revenue
is desired
 Bundled Product – a package of two or more products or services that are
sold for single price, but individual components of the bundle also may be
sold as separate items at their own “stand-alone” prices
Understand how bundling of products
…two or more product sold for a single-price
Causes revenue allocation issues
---allocating revenues to each product in the bundle to evaluate
managers of individual products
And the methods managers use to allocate revenues
---using the stand alone method or the incremental method
6
72

Methods to Allocate Revenue to Bundled Products
 Stand-Alone (separate) Revenue Allocation Method uses product-
specific information on the products in the bundle as weights for
allocating the bundled revenues to the individual products. Three
types of weights may be used:
1. Selling Prices
2. Unit Costs
3. Physical Units
Allocate the revenues of a bundle
product to the individual products in
that bundle
…using the stand-alone method, the
incremental method, or management
judgment
6
73

Methods to Allocate Revenue to Bundled Products
 Incremental Revenue-Allocation Method ranks individual products in
a bundle according to criteria determined by management and then
uses this ranking to allocate bundled revenues to individual products
(similar to earlier discussed Incremental Cost-Allocation Method)
 The first-ranked product is the primary product
 The second-ranked product is the first incremental product
 The third-ranked product is the second incremental product, etc
74

Summary: Objectives of Service Dept Cost Allocation
 Compute product profitability
--- Cost allocation
 Predict economic effects for planning and control
1. Service capacity planning
2. Service productivity/effectiveness improvement
 Motivate managers
1. through the use of incentives and rewards
1) Increased effort
2) Goal congruence
2. to use resources responsibly
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75

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Summary: Conflicting objectives
How to balance capacity and demand?
1. Functional departments demand more IS services when they are cheaper
leading to overuse of capacity
2. If IS service depts. charge more, demand will decrease, leading to
underuse of capacity

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Summary: Conflicting Objectives – Solutions
77
Use dual rate for more accurate cost allocation
Use budgeted data and have dept’s mutually agree on price
(process) (prevent transfer of inefficiencies between dept’s)
Have more flexible system for innovative dept’s – strategic
priority > cost recovery (in the short term).

78
Summary: The Basis of Cost Allocation?
78
In practice - benefits received and cause-effect are widely
used for a couple of reasons:
 Fairness or equity is difficult to agree on
 Ability to bear criterion raises issues related to cross-
subsidization across users of resources in an organization.
Thus you could argue that there are three types:
 benefits/cause and effect,
 fairness
 ability to bear

79
Summary

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