Prepared by Debby Bloom-Hill CMA, CFM - PowerPoint Presentation

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Prepared by Debby Bloom-Hill CMA, CFMSlide2

CHAPTER 6

Cost Allocation

&

Activity-Based Costing

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Purposes of Cost Allocation

To provide information for decision making

To reduce frivolous use of common resourcesTo encourage evaluation of servicesTo provide “full cost” information

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Learning objective 1: Explain why indirect costs are allocatedSlide4

Purposes of Cost Allocation

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Learning objective 1:

Explain why indirect costs are allocatedSlide5

Purposes of Cost Allocation

Provide information for decision making

When managers use a company resource they are receiving a charge for useAllocated cost should measure the opportunity cost of using a company resourceProvides a useful benchmarkThe closer to the opportunity cost of use, the better the allocation

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Learning objective 1: Explain why indirect costs are allocatedSlide6

Purposes of Cost Allocation

To reduce frivolous use of common resources

When managers are not charged for a service, they may tend to use it for frivolous or nonessential purposesFrivolous use may have hidden cost such as slower serviceAllocation provides incentive for departments to reduce frivolous use

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Learning objective 1: Explain why indirect costs are allocatedSlide7

Purposes of Cost Allocation

To encourage evaluation of services

If costs are not allocated, there is no incentive to evaluate the services and look for lower cost alternativesWith cost allocation, there is a strong incentive to critically evaluate the efficiency and necessity of servicesUsers will certainly bring lower cost alternatives to the company’s attention

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Learning objective 1: Explain why indirect costs are allocatedSlide8

Purposes of Cost Allocation

To provide “full cost” information

GAAP requires full costing for external reporting purposesFull cost information is needed when the company has an agreement whereby revenue received depends upon cost incurredAlso called “cost-plus” contracts

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Learning objective 1: Explain why indirect costs are allocatedSlide9

All of the following are reasons indirect costs are allocated to products, services and departments, except:

To improve decision making

To reduce frivolous use of resourcesTo provide information on variable and fixed costsTo encourage evaluation of servicesAnswer: c Indirect costs are allocated to provide full cost information

Test Your Knowledge 1

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Learning objective 1:

Explain why indirect costs are allocatedSlide10

Cost-Plus Contracts

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Learning objective 1:

Explain why indirect costs are allocatedSlide11

Process of Cost Allocation

Cost allocation is achieved by a three step process

Determine the cost objectiveForm cost poolsSelect an allocation base to relate cost pools to the cost objective

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Learning objective 2: Describe the cost allocation processSlide12

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Learning objective 2:

Describe the cost allocation process

Step 1 – determine the cost objectiveDetermine the product, service, or department that is to receive the allocationThe object of the allocation is referred to as the cost objectiveFor example, if computer costs are allocated to contracts worked on, the contracts are the cost objectivesProcess of Cost AllocationSlide13

Process of Cost Allocation

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Learning objective 2:

Describe the cost allocation processSlide14

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Learning objective 2:

Describe the cost allocation process

Process of Cost AllocationSlide15

In the cost allocation process, the cost objective is the:

The allocation base used to allocate the costs

A grouping of individual costs whose total is allocated using one allocation baseThe product, service or department that is to receive the allocationNone of the aboveAnswer: c

The product, service or department that is to receive the allocation

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Learning objective 2:

Describe the cost allocation process

Test Your Knowledge

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Step 2 – form cost pools

A cost pool is a grouping of individual costs whose total is allocated using one allocation base

Cost pools can be organized along departmental lines or major activities, e.g. equipment setups, inspections.Costs in the pool must be homogeneous (similar)

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Learning objective 2: Describe the cost allocation processProcess of Cost AllocationSlide17

Step 3 – select an allocation base that relates the cost pool to the cost objectives

The base must be some characteristic that is common to all of the cost objectives

Deciding which base to use is not easyThe allocation should be based on a cause-and-effect relationshipEstablishing cause-and-effect relationships is not feasible when indirect costs are fixedAccountants use other methods which are shown on the next slide

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Learning objective 2: Describe the cost allocation processProcess of Cost AllocationSlide18

Fixed Indirect Costs – Other Approaches

Relative benefits approach to allocation

More costs allocated to those objectives that benefit most from incurring the costAbility to bear costsMore costs allocated to products, services or departments that are more profitableEquity approach to allocationBase results in allocations that are perceived to be fair or equitable

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Learning objective 2: Describe the cost allocation processSlide19

Select an Allocation Base

Two production departments: Assembly and Finishing

Both receive allocations of indirect costs from the maintenance departmentShould labor hours or machine hours be used as the allocation base?

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Learning objective 2: Describe the cost allocation processSlide20

Selecting an Allocation Base

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Learning objective 2:

Describe the cost allocation processSlide21

In the cost allocation process, an allocation base:

Must be some characteristic that is common to all of the cost objectives

Ideally should result in cost being allocated based on a cause-and-effect relationshipBoth a and bNone of the aboveAnswer: c Both a and b

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Learning objective 2:

Describe the cost allocation process

Test Your Knowledge

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Allocating Service Department Costs

Organizational units of manufacturing firms classified as either:

Production departmentsEngage in direct manufacturing activityService departmentsProvide indirect supportCost poolsFormed by service departmentsAllocated to production departments

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Learning objective 3: Discuss allocation of service department costsSlide23

Direct Method – Mason Furniture

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Allocate janitorial cost of $100,000Allocation base: square feet Assembly department: 20,000 square feet Finishing department: 30,000 square feetCalculate the allocation rate: $100,000 / (20,000 + 30,000) = $2/sq

ftAllocation to production departments: Assembly dept.:20,000 sq ft x $2 = $40,000 Finishing dept.: 30,000 sq ft x $2 = $60,000

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Discuss allocation of service department costsSlide24

Direct Method – Mason Furniture

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Allocate personnel cost of $200,000Allocation base: number of employees Assembly department: 60 employees Finishing department: 40 employeesCalculate the allocation rate: $200,000 / (60 + 40) = $2,000/employeeAllocation to Production DepartmentsAssembly

dept: 60 x $2,000 = $120,000Finishing dept: 40 x $2,000 = $80,000

Learning objective 3:

Discuss allocation of service department costsSlide25

Direct Method of Allocating Service Department Costs

Service department costs allocated to production departments but not to other service departments

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Learning objective 3: Discuss allocation of service department costsSlide26

The direct method of allocating costs:

Allocates service department costs to other service departments

Allocates only direct costsAllocates service department costs to production departments onlyBoth b and c

Answer: cAllocates service department costs to production departments only

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Learning objective 3:

Discuss allocation of service department costs

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Direct Method – Mason Furniture

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Learning objective 3:

Discuss allocation of service department costsSlide28

Taylor Bath has three production departments and allocates mailroom costs of $600,000 based on number of employees

Showers:

80 employeesBathtubs: 40 employeesVanities: 30 employeesCalculate the mailroom allocation rateThe mailroom allocation rate =

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Learning objective 3:

Discuss allocation of service department costs

Test Your Knowledge

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Taylor Bath has three production departments and allocates mailroom costs of $600,000 based on number of employees

Showers:

80 employeesBathtubs: 40 employeesVanities: 30 employeesUse the allocation rate of $4,000 per employee to allocate the mailroom costs to showers, bathtubs and vanitiesShowers 80 employees * $4,000 rate = $320,000Bathtubs

40 employees * $4,000 rate = $160,000Vanities 30 employees * $4,000 rate = $120,000

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Learning objective 3: Discuss allocation of service department costs

Test Your Knowledge

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Allocating Budgeted and Actual Service Department Costs

Management should allocate based on budgeted rather than actual costs

Allocation of actual amounts allows service department to pass on cost of inefficiencies and waste to production departments

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Learning objective 3: Discuss allocation of service department costsSlide31

Problems with Cost Allocation

Potential problems are brought about by:

Allocations of costs that are not controllableArbitrary allocationsAllocation of fixed costs that make the fixed costs appear to be variable costsAllocations of manufacturing overhead to products using too few overhead cost poolsUse of only volume-related allocation bases

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Learning objective 4: Identify potential problems with cost allocationSlide32

Responsibility Accounting and Controllable Costs

One of the primary uses of managerial accounting is to evaluate the performance of managers and the operations under their control

Evaluation is facilitated by a system which traces revenues and costs to units with related responsibility for generating revenue and controlling costsThis system is referred to as a responsibility accounting system

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Learning objective 4: Identify potential problems with cost allocationSlide33

Responsibility Accounting and Controllable Costs

Cost allocation is generally required in a responsibility accounting system

One unit is often responsible for the costs incurred by another unitSome allocations are not consistent with a responsibility accounting systemManagers should be held responsible for controllable costs onlyControllable costs are affected by a manager’s decisions

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Learning objective 4: Identify potential problems with cost allocationSlide34

Arbitrary Allocations

Cost allocations are inherently arbitrary

Typically there are numerous allocation bases that are equally justifiableIn almost all situations, determining the true allocation is impossibleManagers support the allocation which makes them look bestManagers reject allocations which cast an unfavorable light on their performance

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Learning objective 4: Identify potential problems with cost allocationSlide35

Unitized Fixed Costs

The allocation process may make fixed costs appear to be variable costs

This happens when fixed costs are unitizedUnitized fixed costs are stated on a per unit basisWhen managers increase sales they also increase their allocated general and administrative costsThis could lead to decisions which could hurt the profitability of the company

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Learning objective 4: Identify potential problems with cost allocationSlide36

Lump Sum Allocations

Allocations of fixed costs can be made that they appear fixed to managers

This is achieved by lump-sum allocations of fixed costsA lump-sum allocation is not affected by changes in the activity level of the organizational unitLump-sum allocations generally should remain the same from year to year

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Learning objective 4: Identify potential problems with cost allocationSlide37

When fixed costs are stated on a per unit basis:

Fixed costs are said to be controllable

Fixed costs may appear to be variable to managers receiving allocationsA lump-sum allocation has been madeDivisions with high sales receive a low amount of allocated costsAnswer: bFixed costs may appear to be variable to managers receiving allocations

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Learning objective 4:

Identify potential problems with cost allocation

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Too Few Cost Pools

Some companies assign overhead to products using only one or two overhead cost pools

Although simple, this may lead to distortion of cost allocationSome products will be overcostedSome products will be undercostedThis problem is solved by setting up separate cost pools for overhead

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Learning objective 4: Identify potential problems with cost allocationSlide39

Product costs will be more accurate when more overhead cost pools are

used

Decisions that rely on product cost information will be improvedHowever, more cost pools equals more expensive record keepingMust analyze cost-benefit relationship of more cost pools

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Learning objective 5: Discuss activity-based costing (ABC) and cost driversToo Few Cost PoolsSlide40

Using Only Volume-Related Allocation Bases

Some firms allocate manufacturing overhead based on volume, using allocation bases like

Direct labor hours, or Machine hoursNot all overhead costs vary with volumeReferred to as the traditional approach

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Learning objective 4: Identify potential problems with cost allocationSlide41

Using Only Volume-Related Allocation Bases

The problem with the traditional approach is that it assumes that all overhead costs are proportional to production volume

Many overhead costs are not proportional to volumeThe cost of setting up equipment for a production runThe cost of inspecting raw materialsAmong others

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Learning objective 4: Identify potential problems with cost allocationSlide42

Which of the following is not a volume-related cost driver?

Direct labor hours

Direct labor costMachine timeTime to set up a production runAnswer: dA production run will take the same amount of time to set up no matter how many units are in the production run

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Learning objective 4:

Identify potential problems with cost allocation

Test Your Knowledge

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Activity-Based Costing (ABC)

Using the ABC approach, companies identify major activities that cause overhead costs to be incurred

Some activities are related to production volume, some are notThe cost of resources consumed performing these activities are grouped into cost pools Costs are assigned to products using a measure of activity referred to as a cost driver

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Learning objective 5: Discuss activity-based costing (ABC) and cost driversSlide44

The ABC Approach

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Learning objective 5:

Discuss activity-based costing (ABC) and cost driversSlide45

Relating Cost Pools to Products Using Cost Drivers

The company will estimate the total cost assigned to each cost pool

The company will then decide on an appropriate driver, such as number of inspections for inspection costsThe company will then estimate the activity in the driverThe overhead allocation rate is:

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Learning objective 5:

Discuss activity-based costing (ABC) and cost driversSlide46

Common Activities and Associated Cost Drivers

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Learning objective 5:

Discuss activity-based costing (ABC) and cost driversSlide47

McMaster Screen Technologies has two products and allocates overhead costs using a rate of $4 per dollar of labor.

One product has a very low gross profit and the other has a very high gross profit

The CFO suspects that this may be due to problems with the costing systemThe CFO authorizes a study of how product costs will change if an ABC approach is taken

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Learning objective 5: Discuss activity-based costing (ABC) and cost driversActivity Based Costing- McMaster Screen TechnologiesSlide48

The study finds that overhead cost is related to 7 drivers shown on the next slide

The ABC approach reveals that the high-volume product is very profitable

However, the selling price does not come close to covering the full cost of the low volume productThe CFO’s intuition that the traditional product costing might be providing misleading information is correct

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Learning objective 5: Discuss activity-based costing (ABC) and cost driversActivity Based Costing- McMaster Screen TechnologiesSlide49

Activity Based Costing-

McMaster Screen Technologies

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Learning objective 5: Discuss activity-based costing (ABC) and cost driversSlide50

Power Electronics uses two cost pools

Equipment setups

Total estimated cost $1,500,000Estimated setups 10,000InspectionsTotal estimated cost $3,000,000Estimated inspections 15,000Calculate the cost per driver unit for each poolEquipment setups $1,500,000 / 10,000 = $150 per setupInspections $3,000,000 / 15,000 = $200 per inspection

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Learning objective 5:

Discuss activity-based costing (ABC) and cost driversSlide51

Power Electronics has two products:

EP150

10 setups3 inspectionsEP17540 setups8 inspectionsCalculate the overhead applied to EP150Equipment setups 10 * $150 per setup = $1,500Inspections 3 * $200 per inspection = $600Total overhead $1,500 + $600 = $2,100

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Learning objective 5:

Discuss activity-based costing (ABC) and cost driversSlide52

Power Electronics has two products:

EP150

10 setups3 inspectionsEP17540 setups8 inspectionsCalculate the overhead applied to EP175Equipment setups 40 * $150 per setup = $6,000Inspections 8 * $200 per inspection = $1,600Total overhead $6,000 + $1,600 = $7,600

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Learning objective 5:

Discuss activity-based costing (ABC) and cost driversSlide53

Pros and Cons of ABC

Benefits

Less likely to undercost complex low volume products and overcost simple high volume productsDrivers used in ABC are not always volume relatedABC may lead to improvements in cost controlCosts are not buried in one or two pools

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Learning objective 5: Discuss activity-based costing (ABC) and cost driversSlide54

Pros and Cons of ABC

Limitations

More costly to develop and maintain than a traditional costing systemAllocations are made from each cost pool to each productUsed to develop full cost of productsIncludes fixed costsLacks incremental information necessary for decision making

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Learning objective 5: Discuss activity-based costing (ABC) and cost driversSlide55

Fixed and Variable Costs

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Learning objective 5:

Discuss activity-based costing (ABC) and cost driversSlide56

Activity-Based Management

A tool that involves analyzing and costing activities with the goal of improving efficiency and effectiveness

ABC focus is on measuring cost of products and servicesABM focus is on goal of managing the activities themselvesFor example, ABC would calculate the cost per equipment setupABM would focus on ways to improve the setup process and reduce setup cost

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Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)Slide57

Activity-Based Management

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Learning objective 6:

Distinguish activity-based costing (ABC) from activity-based management (ABM)Slide58

Cost Allocation and Decision Making

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Learning objective 6:

Distinguish activity-based costing (ABC) from activity-based management (ABM)Slide59

Appendix

The steps in activity-based management are:

Determine major activitiesIdentify resources used by each activityEvaluate the performance of the activitiesIdentify ways to improve the efficiency and/or effectiveness of the activities

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Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)Slide60

Copyright

© 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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