Hi, Else here.
Today I'll be covering why and how to allocate
service department costs.
But let's start with a blast from the past,
just to remind you about past terms or concepts
that you'll need.
Overhead are those costs required to run a business,
but they don't directly lead to the generation of profit.
Overhead is also known as burden, or indirect costs.
They are indirect because they can't be directly traced
to any specific business activity, product, or service.
But they do provide critical support
for the generation of profit-making activities,
and are therefore necessary.
Overhead costs tend to be fixed, which
means that they don't change from period to period
or with the level of activity.
Examples are rent and depreciation.
However, total overhead is generally
a mixed cost made up of both fixed and variable cost.
It should also be noted that overhead costs can make up
a large portion of the company's overall costs.
As such, the allocation of these indirect overhead costs
becomes critical to a company's overall success.
A cost driver is an activity that, when it changes,
causes a change in the costs.
For example, the number of square feet in a building
will drive the cost of janitorial services.
Why?
Because the more square feet there are,
the longer it takes to clean the space.
More space equals higher janitorial costs.
Specifically, a cost driver is an activity
that is the root cause of why a cost occurs.
Companies that want to know the true costs of their products
and services need to know what is driving
their indirect overhead costs.
For this reason, the company may use multiple cost drivers
to ensure they get a better idea of what's driving their costs.
Now that I've reminded you about some basic terms, let's move
on to an important question.
What is a service department?
Well, to understand service departments,
you first have to understand operating departments.
Operating departments-- also called
profit centers or revenue-generating departments
or producing departments-- are directly
responsible for creating goods or services,
and these will be sold to external customers or clients.
In manufacturing, the operating departments
are the ones that work directly on the products being
manufactured, such as grinding, machining,
and assembly departments.
In a wholesale or retail business,
operating departments are responsible for selling
merchandise to customers.
And in a service business, operating departments
provide services to customers.
In all of these examples, the operating department
generates revenue for the business.
Service departments-- also called
cost centers or support departments--
provide services to support the businesses' operating
departments.
Examples include maintenance, information technology,
custodial services, accounting, marketing,
general administration, and human resource departments.
These departments are critical to the running of the business.
In fact, businesses could not exist
without these departments, but they don't in and of themselves
generate revenue.
Once a business has identified their operating and service
departments, they can trace the direct overhead costs--
direct to the department, but indirect
to the product or service.
These are costs that belong exclusively to each department.
For example, the IT Department would
have direct costs such as salaries for the individuals
who work in the department, supplies,
depreciation on the equipment the department uses.
All of these costs are directly traceable to the IT department,
but indirect to the product or service
the company actually produces.
Great, now we have operating departments
with their own direct overhead costs and service departments
with their own direct overhead costs.
Using financial accounting standards--
either IFRS or ASPE--
how should the business record the direct overhead costs
for service departments such as marketing and human resources?
They are treated as period costs--
basically, operating expenses-- when
preparing the financial statements
for external reporting purposes.
Period costs are excluded from inventoriable costs
by financial accounting standards.
They therefore appear as operating expenses
on the income statement.
Why are we trying to allocate service department costs when
accounting standards clearly indicate
how they should be reported?
Because managerial accounting is not
concerned with external reporting, but with measuring,
monitoring, and motivating behavior
in a business environment.
Support department costs are allocated for objectives--
reasons-- other than financial reporting.
Let's look at some of the reasons
for allocating support department costs.
First, support department costs are
allocated to provide information for strategic and operating
business decisions.
For instance, pricing of products and services
would be one example.
Because operating departments are the only departments
whose activities generate revenue,
the price of the goods or services they produce
must cover all of the costs, including the cost of service
department activities.
Full costing requires that all period
costs be allocated to the product or service
on some reasonable basis.
This is not only true for existing products, but also
new product or market introductions.
Another strategic decision that requires full costing
is whether a product or service should be outsourced.
For instance, if a business made a decision
to outsource the production of a component,
then knowing the full cost of that component
is critical in order to make a decision.
Strategic and operating decisions
are an important objective of allocating service department
costs.
Second, support department costs might
be allocated to motivate managers or employees.
By allocating service department costs to operating departments,
it ensures that managers are aware of the fact
that their activities result in costs outside
of their own department.
It also provides incentives for the managers
to use the services provided efficiently and appropriately.
Inefficient use of service department's resources
may result in higher overall costs.
Motivating management and employees
is another critical objective of allocating service department
costs.
Third and last, service department costs
might be allocated for reimbursement purposes.
What does this mean?
Contracts with external customers
to provide goods or services may stipulate
which costs will be reimbursed and which must be excluded.
For example, universities may be permitted
to allocate a portion of the overhead costs for service
departments to federally-funded programs.
Allocating service department costs
will therefore increase the amount of funds received.
This type of reimbursement is common with government
contracts.
You can see that all three of the main objectives
for allocating service department costs
have nothing to do with financial reporting,
but they have a lot to do with managing the business
for decision making.
Now that we understand the importance
of allocating service department overhead costs with regards
to business decision making, what methods can be
used to allocate those costs?
There are a few, and when deciding between methods,
the most important thing is being
able to justify the method you choose to allocate those costs.
In fact, the justification is one
of the ways we choose the method that we actually
use to allocate service department costs.
There are basically four criteria
that will help to justify your cost allocation decision,
and therefore help you to choose a method.
One-- an activity of the operating department
causes the costs to happen and can be tracked.
Two-- the operating department clearly
receives the benefit, which is an outcome of a cost.
Three-- the cost is reasonable, or fair,
given the circumstances.
And four-- the operating department
has the ability to bear the cost.
Businesses generally use one of these
to support their allocation of service department costs
and their choice of a method.
We'll only explore two of these--
number one and number four.
And I'll be doing that in the next video.