© 2007 Pearson Education Canada Slide 5-1 Cost Allocation and Activity-Based Costing Systems 5

© 2007 Pearson Education Canada Slide 5-2 Cost Allocation Cost allocation attempts to identify some cost or group of costs with one or more cost objectives Cost objectives may be products, departments or divisions Ideally, the cost-allocation base or cost driver should link the cost to the cost objective that caused it Cost pool is a group of individual costs that are allocated to cost objectives using a single cost driver Why allocate costs? Allocate to obtain desired motivation Allocate to compute income and asset valuations Allocate to justify costs and obtain reimbursement Difficult to achieve all three purposes at once Cost allocations often cause discontent and confusion for managers

© 2007 Pearson Education Canada Slide 5-3 Three Types of Cost Allocation Allocation of joint costs to the appropriate responsibility center Reallocation of costs from one centre to another Allocation of costs of a unit to its outputs or products or services Allocation Type 3Cost Object 3 Costs allocated to products,Products, jobs or projects jobs or projects Allocation Type 1Cost Object 1 Costs allocated toResponsibility centres responsibility centres Cost accounting system accumulates costs Allocation Type 2Cost Object 2 Costs allocated from oneResponsibility centres responsibility centre to anotherreceiving products or services

© 2007 Pearson Education Canada Slide 5-4 Allocation of Service Department Costs General Guidelines Allocate costs based on the activity (cost driver) which caused the cost to be incurred Always evaluate performance using budgets Charge variable and fixed cost pools separately Establish details of cost allocation procedures in advance Variable Cost Pool Allocate variable costs of service department based on usage at budgeted rates variable=budgetedxactual volume cost allocationunit rateof usage Fixed Cost Pool Allocate fixed costs based on the budgeted amount of capacity in the service department required by each user department fixed=budgeted fraction ofxtotal budgeted cost allocationcapacity availablefixed costs

© 2007 Pearson Education Canada Slide 5-5 Allocating Service Costs – Direct Method Allocate service department costs directly to production departments only Direct costs$126,000$24,000$100,000$160,000$410,000 Step 1: Facilities(126,000) 105,000 21,000 Step 2: Personnel (24,000) 4,800 19,200 Totals$0$0$209,800$200,200$410,000 ServiceProductionDepartments FacilitiesPersonnelRestaurantsAccom.Total

© 2007 Pearson Education Canada Slide 5-6 Allocating Service Costs - Step Method Recognize that some service departments work for other service departments so allocate to all departments sequentially Direct costs$126,000$24,000$100,000$160,000$410,000 Step 1: Facilities(126,000)42,00070,00014,000 66,000 Step 2: Personnel (66,000) 13,20052,800 Totals$0$0$183,200$226,800$410,000 ServiceProductionDepartments FacilitiesPersonnelRestaurantsAccom.Total

© 2007 Pearson Education Canada Slide 5-7 Allocating Service Costs - Reciprocal Method Recognize that all service departments work for other service departments so allocate to all departments Direct costs$126,000$24,000$100,000$160,000$410,000 Step 1: Facilities(129,220)43,07371,78914,358 Step 2: Personnel 3,192 (67,030) 12,76851,070 Totals$0$0$184,557$225,428$410,000 ServiceProductionDepartments FacilitiesPersonnel RestaurantsAccom.Total

© 2007 Pearson Education Canada Slide 5-8 Allocating Cost to Outputs Allocate production-related costs to the production or revenue-producing departments Select one or more cost drivers in each production department Allocate (or assign) total costs to products or services produced by the department RestaurantsAccommodation Total costs after allocating service department costs (step-down approach)$183,200$226,800 Divided by cost driver customer receipts30,000 direct labour hours10,000 Cost allocation $6.11$22.68 base per customer receipt per direct labour hour

© 2007 Pearson Education Canada Slide 5-9 Allocating Joint and By-Product Costs Joint costs: Inputs of material, labour and overhead incurred before the split-off point Separable Costs: Identifiable with specific end products By-product: A product with relatively insignificant sales value identifiable after the split-off point Chemical X 1,000,000 litres $0.09 per litre = $90,000 Chemical Y 500,000 litres $0.06 per litre = $30,000 Joint Costs $100,000 Chemical YA Separable Processing Costs $20,000

© 2007 Pearson Education Canada Slide 5-10 Allocation of Joint Costs Physical Units Basis Allocate joint costs based on the relative physical measurement of the products after the split-off point Often difficult to determine a reasonable unit of measure which is common to all products RelativeAllocation of ProductLitresWeightingJoint Cost X1,000,00010/15$66,667 Y 500,0005/15 33,333 Total1,500,000$100,000

© 2007 Pearson Education Canada Slide 5-11 Allocation of Joint Costs Sales Value at Split-Off Basis Allocate joint costs based on the relative sales value of the products after the split-off point Allocations are interdependent Sales ValueRelativeAllocation of Split-offWeightingJoint Cost X$90,00090/120$75,000 Y 30,00030/120 25,000 Total$120,000 $100,000

© 2007 Pearson Education Canada Slide 5-12 Activity-Based Costing (ABC) Allocation of indirect costs to products/services in relation to the activities which caused them to be incurred For example, apply more "quality control" costs to those products which require more quality control testing Results in more accurate measurements of product costs Causes attention to be directed on activities rather than products

© 2007 Pearson Education Canada Slide 5-13 Traditional Cost System Direct Material Costs Direct Labour Costs Overhead Costs Direct Trace Direct Trace DLH Allocation Products

© 2007 Pearson Education Canada Slide 5-14 ABC Cost System Direct Material Costs Direct Labour Costs Overhead Costs Direct Trace Direct Trace Products Machining activity costs Assembly activity costs Inspection activity costs # of parts Processing Hours # of inspections

© 2007 Pearson Education Canada Slide 5-15 Steps in ABC Costing Step 1Determine cost objectives, key activity centres, resources, and related cost drivers Step 2Develop a process-based map representing the flow of activities, resources, and their relationships Step 3Collect relevant data concerning costs and the physical flow of cost-driver units among resources and activities Step 4Calculate and interpret the new ABC information

© 2007 Pearson Education Canada Slide 5-16 Activity-Based Accounting Example Account Inquiry $205,332 Corresp- ondence $35,384 Account Billing $235,777 Account Verification $88,847 Residential Customers $273,893 Commercial Customers $291,447 $62.22 per labour hour $12.64 per letter $0.097 per line $4.44 per account Cost PoolsCost ObjectsCost Drivers

© 2007 Pearson Education Canada Slide 5-17 Cost Management Systems Cost Management System identifies how management’s decisions affect costs Activity-Based Management (ABM) distinguish between value-added and non-value-added costs eliminate non-value-added cost without affecting the value of the product to the customer Just-In-Time (JIT Systems) focus on eliminating waste and improving quality purchase material and produce products when needed focus on quality shorter production cycle times smooth the flow of production adopt more flexibility with facilities and employees