Dual Charging Rates
While the use of a single rate is simple, it ignores the differential impact of changes in usage on costs. The variable costs of a support department increase as the level of service increases. For example, the costs of paper and toner for the photocopying department increase as the number of pages copied increases. Fixed costs, on the other hand, do not vary with the level of service. For example, the rental payment for photocopying machines does not change as the number of pages increases or decreases. We can avoid the treatment of fixed costs as variable by developing two rates: one for fixed costs and one for variable costs. The development of dual charging rates (which are used as the basis for pricing) is particularly important in companies such as public utilities
Developing a Fixed Rate
Fixed service costs can be considered capacity costs; they are incurred to provide the capacity necessary to deliver the service units required by the producing departments. When the support department was established, its delivery capability was designed to serve the long-term needs of the producing departments. Since the original support needs caused the creation of the support service capacity, it seems reasonable to allocate fixed costs based on those needs.
Either the normal or peak activity of the producing departments provides a reasonable measure of original support service needs. Normal capacity is the average capacity achieved over more than one fiscal period. If service is required uniformly over the time period, normal capacity is a good measure of activity. Peak capacity allows for variation in the need for the support department, and the size of the department is structured to allow for maximum need. In our example, the tax department may need much more photocopying during the first four months of the year, and its usage may be based on that need. The choice of normal or peak capacity in allocating budgeted fixed service costs depends on the needs of the individual firm. Budgeted fixed costs are allocated in this way regardless of whether the purpose is product costing or performance evaluation.
The allocation of fixed costs follows a 3-step procedure:
1. Determination of budgeted fixed support service costs. The fixed support service costs that should be incurred for a period need to be identified.
2. Computation of the allocation ratio. Using the practical or normal capacity of each producing department, it is necessary to compute an allocation ratio. The allocation ratio simply gives a producing department’s share or percentage of the total capacity of all producing departments.
Allocation ratio= Producing department capacity/Total capacity
3. Allocation. The fixed support service costs are then allocated in proportion to each producing department’s original support service needs
Allocation = Allocation ratio Budgeted fixed support service costs
Let’s assume that the three departments in our example originally decided that they would need the number of photocopies equal to the budgeted number given earlier:
While the use of a single rate is simple, it ignores the differential impact of changes in usage on costs. The variable costs of a support department increase as the level of service increases. For example, the costs of paper and toner for the photocopying department increase as the number of pages copied increases. Fixed costs, on the other hand, do not vary with the level of service. For example, the rental payment for photocopying machines does not change as the number of pages increases or decreases. We can avoid the treatment of fixed costs as variable by developing two rates: one for fixed costs and one for variable costs. The development of dual charging rates (which are used as the basis for pricing) is particularly important in companies such as public utilities
Developing a Fixed Rate
Fixed service costs can be considered capacity costs; they are incurred to provide the capacity necessary to deliver the service units required by the producing departments. When the support department was established, its delivery capability was designed to serve the long-term needs of the producing departments. Since the original support needs caused the creation of the support service capacity, it seems reasonable to allocate fixed costs based on those needs.
Either the normal or peak activity of the producing departments provides a reasonable measure of original support service needs. Normal capacity is the average capacity achieved over more than one fiscal period. If service is required uniformly over the time period, normal capacity is a good measure of activity. Peak capacity allows for variation in the need for the support department, and the size of the department is structured to allow for maximum need. In our example, the tax department may need much more photocopying during the first four months of the year, and its usage may be based on that need. The choice of normal or peak capacity in allocating budgeted fixed service costs depends on the needs of the individual firm. Budgeted fixed costs are allocated in this way regardless of whether the purpose is product costing or performance evaluation.
The allocation of fixed costs follows a 3-step procedure:
1. Determination of budgeted fixed support service costs. The fixed support service costs that should be incurred for a period need to be identified.
2. Computation of the allocation ratio. Using the practical or normal capacity of each producing department, it is necessary to compute an allocation ratio. The allocation ratio simply gives a producing department’s share or percentage of the total capacity of all producing departments.
Allocation ratio= Producing department capacity/Total capacity
3. Allocation. The fixed support service costs are then allocated in proportion to each producing department’s original support service needs
Allocation = Allocation ratio Budgeted fixed support service costs
Let’s assume that the three departments in our example originally decided that they would need the number of photocopies equal to the budgeted number given earlier:
The fixed costs allocated, then, are the relevant percentages for each department multiplied by the support department’s budgeted fixed costs.
Developing a Variable Rate
The variable rate depends on the costs that change as the activity driver changes. In the photocopying department, the activity driver is the number of pages copied. As the number of pages increases, more paper and toner are used. Since these materials average $0.023 per page, the variable rate is $0.023. This variable rate is used in conjunction with the fixed amount allocated to determine total charges. In our example, the audit department would be allocated 35 percent of fixed cost plus $0.023 per page copied. The tax department would be allocated 25 percent of fixed cost plus $0.023 per page copied. MAS would be allocated 40 percent of fixed cost plus $0.023 per page copied. Let’s see how variable photocopying costs are allocated under the dual-rate method.
Developing a Variable Rate
The variable rate depends on the costs that change as the activity driver changes. In the photocopying department, the activity driver is the number of pages copied. As the number of pages increases, more paper and toner are used. Since these materials average $0.023 per page, the variable rate is $0.023. This variable rate is used in conjunction with the fixed amount allocated to determine total charges. In our example, the audit department would be allocated 35 percent of fixed cost plus $0.023 per page copied. The tax department would be allocated 25 percent of fixed cost plus $0.023 per page copied. MAS would be allocated 40 percent of fixed cost plus $0.023 per page copied. Let’s see how variable photocopying costs are allocated under the dual-rate method.
Total Allocation
Under the dual charging rates, the fixed photocopying rates are charged to the departments in accordance with their original capacity needs. Especially in a case like this one, in which fixed costs are such a high proportion of total costs, the additional effort needed to develop the dual rates may be worthwhile. The dual-rate method has the benefit of sending the correct signal regarding increased usage of the support department. Suppose that the tax department wants to have several research articles on tax law changes photocopied for clients. Should this be done “in house” by the photocopying department or sent to a private photocopying firm that charges $0.06 per page? Under the single-rate method, the in-house cost charged would be too high because it wrongly assumes that fixed cost will increase as pages copied increase. However, under the dual-rate method, the additional cost would be only $0.023 per page, which correctly approximates the additional cost of the job. Also read direct method of allocation and sequential method of allocation
Under the dual charging rates, the fixed photocopying rates are charged to the departments in accordance with their original capacity needs. Especially in a case like this one, in which fixed costs are such a high proportion of total costs, the additional effort needed to develop the dual rates may be worthwhile. The dual-rate method has the benefit of sending the correct signal regarding increased usage of the support department. Suppose that the tax department wants to have several research articles on tax law changes photocopied for clients. Should this be done “in house” by the photocopying department or sent to a private photocopying firm that charges $0.06 per page? Under the single-rate method, the in-house cost charged would be too high because it wrongly assumes that fixed cost will increase as pages copied increase. However, under the dual-rate method, the additional cost would be only $0.023 per page, which correctly approximates the additional cost of the job. Also read direct method of allocation and sequential method of allocation
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