Managerial Accounting by James Jiambalvo Chapter 5: Cost Allocation and Activity-Based Costing Slides Prepared by: Scott Peterson Northern State University

Chapter 5: Cost Allocation and Activity-Based Costing Chapter Themes: Think about how much products really cost to produce. How do you measure that? Focus on indirect costs (not direct labor or direct materials). Remember—You Get What You Measure! Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purposes of Cost Allocation Companies allocate costs for four major reasons: To provide information needed for decision making. To reduce the frivolous use of common resources. To encourage managers to evaluate the efficiency of internally provided services. To calculate the full cost of products for financial reporting purposes and for determining cost-based prices. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #1: To Provide Information for Decision Making Generally, as resources are consumed during production, cost allocations are made to the products, departments etc… much like a fee or charge. From a decision making standpoint, the allocated cost should measure the opportunity cost of using a company resource. Unfortunately this is difficult to implement in practice as opportunity costs can change quickly. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #2: To Reduce Frivolous Use of Common Resources It may be argued that fixed costs should not be allocated at all. But without charging a fee (or allocating these costs), resources are often used frivolously or for nonessential purposes. Consider fixed costs associated with computer resources. Examples include recreational web surfing, playing games, sending personal e-mail etc… One way to eliminate frivolous use is to charge for it. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #3: To Encourage Evaluation of Services Cost allocation is also useful because is causes management to evaluate the services for which they are being charged (e.g. costs allocated to their departments or products). For example, centrally administered services such as janitorial or computer services should be allocated to various departments. If these services were free and no allocation were made, users would not consider them. But if a charge is levied, management has a strong incentive to evaluate these services and charges and consider alternatives. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #4: To Provide “Full” Cost Information First of all, GAAP requires “Full Costing” for external reporting purposes. As a result indirect production costs must be allocated to goods produced. Furthermore, full cost information is required when a contract calls for “Cost Plus” pricing. In this case not only is manufacturing overhead allocated, but so are other general and administrative costs. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Process of Cost Allocation Cost allocation has three steps: identify the cost objectives, form cost pools, select an allocation base to relate the cost pools to the cost objectives. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Determining the Cost Objective The first step in the cost allocation process is to determine the product, service or department that is to receive the allocation. The object of this cost allocation is called the cost objective. See the next slide for examples. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Determining the Cost Objective (Graphic) Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Forming Cost Pools The second step in the cost allocation process is to form cost pools. A cost pool is a grouping of individual costs whose total is allocated using one allocation base. For example, maintenance department costs might constitute a cost pool. Cost pools are often formed along department lines. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Selecting an Allocation Base The third step in the allocation process is to select an allocation base that relates the cost pool to the cost objectives. If the cost objectives are manufactured products, then direct labor hours, direct labor dollars or machine hours are examples of characteristics that could be used as allocation bases. Ideally, the allocation base should relate costs to cost objectives. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM). More

Selecting an Allocation Base When indirect costs are fixed, establishing a cause-and-effect relationship is infeasible. So, accountants use other criteria: Relative benefits (the allocation base should result in more costs being allocated to the cost objectives that benefit most from incurring the cost). Ability to bear costs (the allocation base should result in more costs being allocated to products which are more profitable). Equity (the allocation base should result in allocations which are fair and equitable. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Allocating Service Department Costs Organizational units in most manufacturing firms are often classified by department; either production or service. Since service departments, like maintenance, are support departments, their costs are pooled and allocated to production departments. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Direct Method of Allocating Service Department Costs The text book uses a method of allocating service department costs called the direct method. Here, service departments are allocated to production departments, but not other service departments. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Allocating Budgeted and Actual Service Department Costs Budgeted rather than actual service costs should be allocated to production departments. Because if budgeted costs are allocated, service department inefficiencies cannot be passed on to production departments. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Problems With Cost Allocation A number of problems may arise when costs are allocated. They may be brought about by allocations of costs that are not controllable, arbitrary allocation, allocations of fixed costs that make the fixed costs appear to be variable costs, allocation of manufacturing overhead to products using too few overhead cost pools, and use of only volume-related allocation bases. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Responsibility Accounting and Controllable Costs Responsibility accounting requires tracing revenues and costs to organizational units and individual managers with related responsibility for generating revenue and controlling costs. Furthermore cost allocations are consistent with responsibility accounting. But, only costs for which the individual manager has control. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Arbitrary Allocations As might be expected, cost allocation fairness is the topic of heated management discussions. Unfortunately, allocations of costs are inherently arbitrary. It is impossible to determine the “true” or “correct” allocation. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Unitized Fixed Costs and Lump-Sum Allocations Another potential problem is that cost allocation may make fixed costs appear variable. This happens when fixed costs are unitized or stated on a per unit basis. Examples include fixed general and administrative costs like administrative salaries. These costs should be allocated in a lump-sum regardless of total production. The reason is that as production rises, more and more fixed costs are added, despite the fact that, by definition, fixed costs are static and do not change with respect to changes in activity levels. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

The Problem of Too Few Cost Pools Assigning costs using just one or two cost pools can cause serious product costing distortions. While easy to implement and use, this approach is not as accurate. Ultimately, a cost-benefit decision has to be made. The question is “does the benefit of more accurate allocation methods (e.g. more accurate product costs) outweigh the cost of obtaining this information?” Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Using Only Volume-Related Allocation Bases. Some manufacturers allocate manufacturing overhead to products using only measures of production volume (labor hours, machine hours). The problem is that not all overhead costs vary in relation to volume. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Activity-Based Costing Activity-Based Costing (ABC) is a relatively recent development in management accounting. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

The Problem of Using Only Measures of Production Volume to Allocate Overhead As discussed a few slides ago, companies commonly use labor hours or machine hours as allocation bases for assigning overhead to products. This “Traditional Approach” assumes that all costs are proportional to production volume. In reality this is not true. For example, setup costs are not proportional. A setup might work for a 400,000 unit production run just as well as a 200,000 production run. As a result, low-volume items are undercosted and high-volume items are overcosted. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

The ABC Approach Related Learning Objectives: In the ABC Approach, companies identify the major activities that cause overhead costs to be incurred. Some of these are related to production volume, but others are not. The steps are as follows: Identify activities. Group costs of activities into cost pools. Identify measures of activities (the cost drivers) Relate costs to products using the cost drivers. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Major Activities Related Learning Objectives: Following are examples of major activities under ABC: Processing purchase orders. Handling materials and parts. Inspecting incoming material and parts. Setting up equipment. Producing goods using manufacturing equipment. Supervising assembly workers. Inspecting finished goods. Packing customer orders. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Associated Costs Costs associated with the preceding major activities have to do with salaries and wages, depreciation on equipment and the like. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Cost Drivers Related Learning Objectives: Following are examples of cost drivers under ABC: Number of purchase orders processed. Number of material requisitions. Number of receipts. Number of setups. Number of machine hours. Number of assembly labor hours. Number of inspections. Number of boxes shipped. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Pros and Cons of ABC Benefits: First, ABC is less likely than traditional costing to undercost or overcost products. Second, ABC may lead to improvements in cost control. Limitations: It’s expensive relative to a traditional system! Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Activity-Based Management Activity-Based Management (ABM) is a management tool with the goal of improving efficiency and effectiveness. It is similar to ABC, except that where ABC focuses on cost measurement, ABM focuses on the the activities themselves. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Remember—You Get What You Measure! How does this statement relate to cost allocation? Allocations affect the profit that managers have reported on their performance reports! Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

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