Cost Allocation and Activity-Based Costing Principles of Financial and Managerial Accounting 11e Principles of Managerial Accounting 11e Chapter 26 Principles of Financial and Managerial Accounting Using excel for Success Student Version These slides should be viewed using the presentation mode (left click your mouse on the icon). Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reeve Warren Duchac

Learning Objective 1 Identify three methods used for allocating factory overhead costs to products. 2

Product Costing Allocation Methods Product Costing Allocation Methods Most companies have accounting systems that trace revenues to individual product lines. In addition, they need to subtract the cost of manufacturing their products from revenues in order to determine the profit from sales. Determining the cost of a product is termed product costing.

Product Costing Allocation Methods Three methods of allocating factory overhead costs are: Single plantwide factory overhead rate method Multiple production department factory overhead rate method Activity-based costing method

Use a single plantwide factory overhead rate for product costing. Learning Objective 2 Use a single plantwide factory overhead rate for product costing.

Single Plantwide Factory Overhead Rate Method LO 2 Single Plantwide Factory Overhead Rate Method Under the single plantwide factory overhead rate method, all of the factory overhead is allocated to all products using only one rate.

Ruiz Company Illustration LO 2 Ruiz Company Illustration Ruiz Company Ruiz Company Illustration Ruiz Company manufactures two products, snowmobiles and riding mowers. Both products are manufactured in a single factory. There is $1,600,000 of factory overhead budgeted for the period.

Ruiz Company Illustration LO 2 Ruiz Company Illustration Ruiz Company Each product is budgeted 10,000 direct labor hours as shown below:

Ruiz Company Illustration LO 2 Ruiz Company Illustration Ruiz Company The plantwide rate is calculated as follows: Total Budgeted Factory Overhead Costs Total Budgeted Plantwide Allocation Base $1,600,000 20,000 direct labor hours $80 per direct labor hour = (1,000 × 10 dlh) + (1,000 × 10 dlh) (continued)

Factory Overhead Cost per Unit LO 2 Ruiz Company Illustration Ruiz Company Snowmobile: $80 per dlh × 10 direct labor hours = $800 Riding Mower: $80 per dlh × 10 direct labor hours = $800 Factory Overhead Cost per Unit

Single Plantwide Factory Overhead Rate Method LO 2 Single Plantwide Factory Overhead Rate Method The primary advantage of the single plantwide overhead rate method is that it is simple and inexpensive to apply in practice.

Learning Objective 3 Use multiple production department factory overhead rates for product costing.

Multiple Production Department Factory Overhead Rate Method LO 3 The multiple production department factory overhead rate method uses different rates for each production department to allocate factory overhead costs to products.

Department Overhead Rates and Allocation LO 3 Ruiz Company Fabrication Department Factory Overhead Rate: $1,030,000 10,000 direct labor hours = $103 per dlh Assembly Department Factory Overhead Rate: $570,000 10,000 direct labor hours = $57 per dlh

Department Overhead Rates and Allocation LO 3 Ruiz Company

Distortion of Product Costs LO 3 Distortion of Product Costs Ruiz Company The differences in factory overhead for each product using the two methods are shown below:

Distortion of Product Costs LO 3 Distortion of Product Costs The following conditions indicate that a single plantwide factory overhead rate may cause product cost distortions: Condition 1: Differences in production department factory overhead rates. Condition 2: Differences among products in the ratios of allocation base usage within a department and across departments.

Use activity-based costing for product costing. Learning Objective 4 Use activity-based costing for product costing.

Activity-Based Costing Method LO 4 Activity-Based Costing Method The activity-based costing method provides an alternative approach for allocating factory overhead that uses multiple factory overhead rates based on different activities. Activities are the types of work, or actions, involved in a manufacturing or service process.

Budgeted Activity Cost LO 4 Activity-Based Costing Method Ruiz Company Budgeted Activity Cost Cutting metal to shape the product Activity Manually assembling machined pieces Fabrication $ 530,000 Assembly 70,000 Setup 480,000 Quality-control inspections 312,000 Engineering changes 208,000 Total budgeted activity costs $1,600,000 Changing tooling in machines in preparation for making a new product Inspecting the product for conformity to specifications An engineering change order (ECO) initiates changing a product or process.

Activity Rates and Allocation Activity Rates and Allocation The budgeted activity costs are assigned to products using factory overhead rates for each activity. These rates are called activity rates because they are related to activities. Activity Rate = Budgeted Activity Cost Total Activity Base Usage The term activity base, rather than allocation base, is used because the base is related to an activity.

Activity-Based Costing Method LO 4 Activity-Based Costing Method Ruiz Company (continued)

Activity-Based Costing Method LO 4 Activity-Based Costing Method Ruiz Company (continued)

Activity-Based Costing Method LO 4 Activity-Based Costing Method Ruiz Company (continued)

Activity-Based Costing Method LO 4 Activity-Based Costing Method Ruiz Company

Activity-Based Costing Method LO 4 Activity-Based Costing Method Ruiz Company

Distortion of Product Costs LO 4 Distortion of Product Costs Ruiz Company If Ruiz Company used the $800 factory overhead cost allocation (single plantwide rate) instead of activity-based costing, the following would likely result: The snowmobile would be underpriced because its factory overhead cost is understated by $494 ($1,294 – $800). The riding mower would be overpriced because its factory overhead cost is overstated by $494 ($800 – $306).

Learning Objective 5 Use activity-based costing to allocate selling and administrative expenses to products.

Activity-Based Costing for Selling and Administrative Expenses LO 5 Budgeted Warranty Claim Expenses Warranty Claim Activity Rate = Estimated Warranty Claims Warranty Claim Activity Rate = $150,000 100 claims Warranty Claim Activity Rate = $1,500 per claim (continued)

Activity-Based Costing for Selling and Administrative Expenses LO 5 Assuming that Ipso had 10 warranty claims and Facto had 90 warranty claims, the field service activity expense would be allocated as follows: Ipso: $15,000 = 10 warranty claims x $1,500 per warranty claim Facto: $135,000 = 90 warranty claims x $1,500 per warranty claim

Use activity-based costing in a service business. Learning Objective 6 Use activity-based costing in a service business.

Activity-Based Costing in Service Businesses LO 6 Hopewell Hospital Hopewell Hospital uses an activity-based costing system to determine how hospital overhead is allocated to patients.

Activity-Based Costing in Service Businesses LO 6 The budgeted costs for radiological testing are $96,000, based on total estimated activity-base usage of 3,000 images. Activity Rate = Budgeted Activity Cost Total Activity Base Usage Radiological Testing Activity Rate $960,000 3,000 images = = $320 per image

Activity-Based Costing in Service Businesses LO 6 Hopewell Hospital (continued)

Activity-Based Costing in Service Businesses LO 6 Hopewell Hospital (continued)

Activity-Based Costing in Service Businesses 6 LO 6

Cost Allocation and Activity-Based Costing The End