McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Cost Allocation and Performance Measurement Chapter 21

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., One of the most difficult tasks in computing accurate unit costs lies in determining the proper amount of overhead cost to assign to each job. Assigning overhead is difficult. I agree! Overhead Cost Allocation Methods

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., A two-stage process may be used because different departments may have different allocation bases. A two-stage process may be used because different departments may have different allocation bases. Finishing Department Shipping Department Painting Department Two-Stage Cost Allocation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3 Stage One: Costs assigned to departments Two-Stage Cost Allocation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Stage One: Costs assigned to departments Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Stage One: Costs assigned to departments Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Stage Two: Costs applied to jobs Stage One: Costs assigned to departments Jobs Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Jobs Direct Labor Hours Machine Hours Raw Materials Cost Departmental Allocation Bases Stage Two: Costs applied to jobs Stage One: Costs assigned to departments Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Level of Complexity Overhead Allocation Plantwide Overhead Rate Departmental Overhead Rates Activity Based Costing Activity-Based Cost Allocation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., In the ABC method, we recognize that many activities within a department drive overhead costs. In the ABC method, we recognize that many activities within a department drive overhead costs. A BC A C B Activity-Based Cost Allocation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Identify activities and assign indirect costs to those activities. Central idea... Products require activities. Activities consume resources. A BC A C B Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,  More detailed measures of costs.  Better understanding of activities.  More accurate product costs for... Pricing decisions. Product elimination decisions. Managing activities that cause costs.  Benefits should always be compared to costs of implementation.  More detailed measures of costs.  Better understanding of activities.  More accurate product costs for... Pricing decisions. Product elimination decisions. Managing activities that cause costs.  Benefits should always be compared to costs of implementation. Activity-Based Costing Benefits

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Most cost drivers are related to either volume or complexity of production. Examples: machine time, machine setups, purchase orders, production orders. Three factors are considered in choosing a cost driver: Causal relationship. Benefits received. Reasonableness. Most cost drivers are related to either volume or complexity of production. Examples: machine time, machine setups, purchase orders, production orders. Three factors are considered in choosing a cost driver: Causal relationship. Benefits received. Reasonableness. Identifying Cost Drivers

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,  Identify activities that consume resources.  Assign costs to a cost pool for each activity.  Identify cost drivers associated with each activity.  Compute overhead rate for each cost pool:  Assign costs to products: Overhead Actual Rate Activity × Rate = Estimated overhead costs in activity cost pool Estimated number of activity units Activity-Based Costing Procedures

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Let’s look at an example comparing traditional costing with ABC. We will start with traditional costing. Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Pear Company manufactures a product in regular and deluxe models. Overhead is assigned on the basis of direct labor hours. Budgeted overhead for the current year is $2,000,000. Other information: First, determine the unit cost of each model using traditional costing methods. Traditional Costing vs. ABC Example

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Traditional Costing Overhead Estimated overhead costs Rate Estimated activity = Overhead $2,000,000 Rate 40,000 DLH == $50 per DLH

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., ABC will have different overhead per unit. Traditional Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Pear Company plans to adopt activity-based costing. Using the following activity center data, determine the unit cost of the two products using activity-based costing. Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., deluxe regular = 1,200 total Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Let’s complete the table. Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Activity-Based Costing Total overhead = $720,000 + $1,280,000 = $2,000,000 Recall that $2,000,000 was the original amount of overhead assigned to the products using traditional overhead costing.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Activity-Based Costing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., This result is not uncommon when activity-based costing is used. Many companies have found that low-volume, specialized products have greater overhead costs than previously realized. Traditional Costing vs. ABC

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Costs and Cost Drivers in Activity-Based Costing Exh. 21-6

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Provide information for managers to use in performance evaluation. Assign costs to managers who are responsible for controlling the costs. Primary goals Departmental Accounting

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Large complex businesses are divided into departments enabling managers to have a smaller effective span of control. Departmental Accounting

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departments are established for specialized functions. ProductionSalesService Departmental Accounting

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Managers use this information to : Allocate resources. Control operations. The accounting system provides information about resources used and outputs achieved. Appraise performance Corrective Action Information for Departmental Evaluation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., The type of accounting information provided depends on whether the department is a... Evaluated on ability to control costs. Evaluated on ability to generate revenues in excess of expenses. Cost center Profit center Information for Departmental Evaluation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Quality Customer Satisfaction Profitability Cost Effectiveness Information must support these four pillars of any successful business Information for Departmental Evaluation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Direct expenses are incurred for the sole benefit of a specific department. Indirect expenses benefit more than one department and are allocated among departments benefited. Departmental Expense Allocation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Illustration of Indirect Expense Allocation Exh. 21-7

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Illustration of Indirect Expense Allocation Exh. 21-7

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Illustration of Indirect Expense Allocation Exh. 21-7

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Service department costs are shared, indirect expenses that support the activities of two or more production departments. Bases for Allocating Service Department Costs Exh. 21-8

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 Service Department Costs Question

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 Assembly percentage = 100 ÷ ( ) = 40% 40% of $300,000 = $120,000 Service Department Costs Question

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Let’s prepare departmental income statements using the following steps: Ê Direct expense accumulation. Ë Indirect expense allocation. Ì Service department expense allocation. Preparing Departmental Income Statements

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Service Dept. One Service Dept. Two Operating Dept. One Direct expenses are traced to each department without allocation. Operating Dept. Two Step 1: Direct Expense Accumulation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Service Dept. One Service Dept. Two Operating Dept. One Indirect expenses are allocated to all departments using appropriate allocation bases. Allocation Step 2: Indirect Expense Allocation Operating Dept. Two

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Operating Dept. One Operating Dept. Two Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to operating departments. Allocation Service Dept. One Service Dept. Two Step 3: Service Department Expense Allocation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Let’s examine this three-step allocation procedure for Owl Company. Departmental Expense Allocation Spreadsheet

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental Expense Allocation Spreadsheet Step 1: Direct expenses are traced to service departments and sales departments without allocation.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental Expense Allocation Spreadsheet Step 2: Indirect expenses are allocated to both the service and the sales departments based on floor space occupied. Of a total of 2,000 square feet, the service departments occupy 200 square feet each, sales department one occupies 600 square feet, and sales department two occupies 1,000 square feet.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Sales department one has $40,000 in sales and sales department two has $48,000 in sales. Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments. Departmental Expense Allocation Spreadsheet

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental Expense Allocation Spreadsheet Sales department one has 28 employees and sales department two has 40 employees. Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental Expense Allocation Spreadsheet

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Now that we have the costs, let’s do an income statement. Departmental Income Statements

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental Income Statements

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental Income Statements

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental contribution... Is used to evaluate departmental performance. Is not a function of arbitrary allocations of indirect expenses. A department may be eliminated when its departmental contribution is negative. Departmental revenue – Direct expenses = Departmental contribution Departmental Contribution to Overhead

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., As a general rule, a department can be considered a candidate for elimination if its revenues are less than its escapable expenses. Direct expenses are usually escapable. Indirect expenses are usually inescapable. Eliminating an Unprofitable Department

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Let’s recast Owl Company’s income statement using the departmental contribution approach where indirect expenses are not allocated. Departmental Contribution to Overhead

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Net income for the company is still $17,500. Departmental Contribution to Overhead

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental contributions to indirect expenses (overhead) are emphasized. Departmental Contribution to Overhead

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Departmental contributions are positive so neither department is a candidate for elimination. Departmental Contribution to Overhead

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Costs are controllable if the manager has the power to determine, or strongly influence, the amounts incurred. A manager’s performance evaluation should be based on controllable costs. I’m in control Controllable Costs

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Direct costs are traced to departments, but may not be controllable by the department manager. Example: Department managers usually have no control over their own salaries. Controllable costs are identified with a particular manager and a definite time period. All costs are controllable at some level of management if the time period is long enough. Distinguishing Controllable and Direct Costs

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., An accounting system that provides information... Responsibility Accounting Relating to the responsibilities of individual managers. To evaluate managers on controllable items.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Responsibility Accounting Successful implementation of responsibility accounting may use organization charts with clear lines of authority and clearly defined levels of responsibility.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Amount of detail varies according to level in organization. A department manager receives detailed reports. A store manager receives summarized information from each department. Responsibility Accounting Performance Reports

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., The vice president of operations receives summarized information from each store. Management by exception: Upper-level management does not receive operating detail unless problems arise. Amount of detail varies according to level in organization. Responsibility Accounting Performance Reports

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., To be of maximum benefit, responsibility reports should... Be timely. Be issued regularly. Be understandable. Compare budgeted and actual amounts. Responsibility Accounting Performance Reports

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., A single cost incurred in producing or purchasing two or more different products. Similar to an indirect expense since it is shared among more than one cost object. Example: The cost of crude oil is a joint cost for many petrochemical products. Joint Costs

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Joint costs Allocation If we allocate the joint costs of raising the animal to the two products based on weight, which product would receive the largest cost allocation? Joint Costs and Their Allocation Hamburger, because there is more of it.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., If we allocate the joint costs of raising the animal to the two products based on sales value, would the steak receive a greater portion of the cost allocation? Yes, steak has a higher sales value than hamburger. Joint costs Allocation Joint Costs and Their Allocation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Allocate the $200,000 joint cost based on sales value. Product One Sales value = $80,000 Product Two Sales value = $200,000 Product Three Sales value = $120,000 $200,000 Joint Cost Value Basis Allocation of Joint Costs

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Value Basis Allocation of Joint Costs

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., End of Chapter 21