Managerial Accounting by James Jiambalvo Chapter 6: Cost Allocation and Activity-Based Costing Slides Prepared by: Scott Peterson Northern State University

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 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.

Purposes of Cost Allocation

Rationale #1: To Provide Information for Decision Making From a decision making standpoint, the allocated cost should measure the opportunity cost of using a company resource.

Rationale #2: To Reduce Frivolous Use of Common Resources By not allocating costs, these resources appear “free” to the users. But resources never come with zero costs.

Rationale #3: To Encourage Evaluation of Services The flip-side of the previous point (to reduce frivolous usage); to compel the current users to evaluate the costs and benefits of the services for which they are being charged (allocated).

Rationale #4: To Provide “Full” Cost Information GAAP requires full-costing for external reporting purposes. In the long-run, all costs must be covered.

Process of Cost Allocation Steps include: Identify the cost objectives Form cost pools Select an allocation base to relate the cost pools to the cost objectives.

Process of Cost Allocation

Determining the Cost Objective Cost Objective: Determine the product, service or department that is to receive the allocation.

Determining the Cost Objective

Forming Cost Pools Cost pool: A grouping of individual costs, the sum of which is allocated using a single allocation base. Cost pools could include: Departments (maintenance or personnel departments) Major Activities (equipment setups)

Selecting an Allocation Base Allocation Base: Very important to choose a base that relates the cost pool to the cost objectives. Allocation should be based on a cause-and-effect relationship between costs and objectives. If cause-and-effect cannot be established, other approaches are used.

Other Approaches to Cost Allocation (Fixed-Indirect) Relative benefits approach. Ability to bear costs. Equity approach. These are all merely accounting convention; allocation for the sake of allocation.

Allocating Service Department Costs Manufacturing firms are often organized either By production department By service department Production department implies a “direct” activity. Service department implies an “indirect” activity.

Direct Method of Allocating Service Department Costs The Direct Method.

Direct Method of Allocating Service Department Costs Bradley Furniture Example:

Allocating Budgeted and Actual Service Department Costs Managers should allocate budgeted rather than actual costs. In this way inefficiencies cannot be passed on to production.

Problems With Cost Allocation Allocation of uncontrollable costs. Arbitrary allocations. Allocations of fixed costs that make the fixed costs appear to be variable. Allocations of manufacturing overhead to products using too few overhead and cost pools. Use of only volume-related allocation bases.

Responsibility Accounting and Controllable Costs (1) Responsibility accounting holds someone in some unit accountable for generating revenue and controlling costs. The trick is to find out whom to hold accountable and at what level. Managers should be held accountable only for controllable costs.

Arbitratry Allocations (2) Cost allocations are inherently arbitrary. Managers frequently make educated guesses.

Unitized Fixed Costs and Lump-Sum Allocations (3) Unitized fixed costs pose a significant problem. Costs that are fixed (in the short run), are often divided by some base and allocated as variable (per-unit). Importantly, this is a question of perspective. The higher up in the hierarchy the manager is, the greater the number of all costs that appear variable.

Lump-Sum Allocations (3) The remedy is to allocate these costs, like clerical and administrative, as lump-sum allocations. Lump-sum allocations should remain the same, year-by-year, regardless of total production. Lump-sum allocations ignore changes in activity-levels.

The Problem With Too Few Cost Pools (4) Too few cost pools cause serious product costing distortions. Generally, the more cost pools, the more accuracy is enhanced. Does the benefit of more accurate allocation methods (i.e.more cost pools) outweigh the cost of obtaining this information?

Using Only Volume-Related Allocation Bases (5) Some manufacturers allocate manufacturing overhead to products using only volume measures (such as): labor hours machine hours Not all overhead costs vary in relation to volume!

Activity-Based Costing Activity-Based Costing (ABC) is a relatively recent development in management accounting.

The Problem of Using Only Measures of Production Volume to Allocate Overhead Traditionally firms use labor hours or machine hours as allocation bases for assigning overhead to products. This assumes that all costs are proportional to production volume. Setup costs are not proportional. For example, a setup might work for a 400,000 unit production run just as well as a 200,000 production run. Low-volume items are undercosted and high-volume items are overcosted.

The ABC Approach Identify the major activities that cause overhead costs to be incurred. Group costs of activities into cost pools. Identify measures of activities (the cost drivers) Relate costs to products using the cost drivers.

The ABC Approach

Examples of Activities 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.

Examples of Associated Costs Various labor costs. Depreciation.

Examples of Cost Drivers 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.

Pros and Cons of ABC Benefits: ABC is less likely than traditional costing to undercost or overcost products. ABC may lead to improvements in cost control. Limitations: Expensive relative to traditional system!

“You Get What You Measure”

Quick Review Question #1 The direct method of allocating costs: Allocates service department costs to other service departments. Allocates only direct costs. Allocates service department costs to production departments only. Both (b) & (c).

Quick Review Answer #1 The direct method of allocating costs: Allocates service department costs to other service departments. Allocates only direct costs. Allocates service department costs to production departments only. Both (b) & (c).

Quick Review Question #2 In the cost allocation process, the cost objective is: The allocation base used to allocate the costs. A grouping of individual costs whose total is allocated using one allocation base. The product, service or department that is to receive the allocation None of these.

Quick Review Answer #2 In the cost allocation process, the cost objective is: The allocation base used to allocate the costs. A grouping of individual costs whose total is allocated using one allocation base. The product, service or department that is to receive the allocation. None of these.

Quick Review Answer #2 Units produced = 2,000, units sold = 1,800, contribution margin ratio is 37%, fixed S & A expenses are $90,000. Fixed mfg. Expenses are $80,200 By how much is net income greater under full costing than variable costing? $8,020 $80,200 $9,000 $17,020

Quick Review Question #3 The errant process of treating fixed costs a variable, or a per-unit basis, is called? A cost driver. A cost object. Unitizing fixed costs. An arbitrary allocation.

Quick Review Answer #3 The errant process of treating fixed costs a variable, or a per-unit basis, is called? A cost driver. A cost object. Unitizing fixed costs. An arbitrary allocation.

Quick Review Question #4 What does it mean to “Get What You Measure?”

Quick Review Answer #4

Appendix: Activity-Based Management (Four-Steps) Determine major activities. Identify resources used by each activity. Evaluate the performance of the activities. Identify ways to improve the effficiency and/or effectiveness of the activities.

Step 1: Determine major activities through interviews and observations Determine customer locations, determine availability of stock, and prepare delivery schedules. Pick orders from warehouse. Load trucks. Deliver merchandise.

Step 1: Determine major activities through interviews and observations (continued) Return merchandise to stock if not acceptable to customer or customer not home. Wash delivery trucks (each night). Schedule truck for routine service and nonroutine repairs.

Step 2: Identify Resources Used By Each Activity (ex.) Return merchandise to stock (e) Different item received than ordered Customer not home at time of delivery Wash delivery trucks (f) How many trucks washed per night? Salary/wage costs associated with employees Cleaning supplies, materials, equipment depreciation

Step 3: Evaluate The Performance Of The Activities Benchmarking. Compare with other firms. How do costs compare with others?

Step 4: Identify Ways To Improve The Efficiency And/Or Effectiveness Of The Actvities Suggest improvements based on analysis. Best practices at other firms. Examples: Have sales staff seek customer input. Have clerk call customers the day prior to delivery to assure someone is home (note: dentists office now do this regularly). Consider converting part-time positions to full-time or outsourcing washing.

Conclusion ABM focuses on process improvements. ABC focuses on costing. ABM often identifies “low hanging fruit,” or costs which are out of line with benchmarks. ABM can produce substantial returns.

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