CHAPTER 6 Cost Allocation & Activity-Based Costing Cost Allocation & Activity-Based Costing Slide 6-2

Purposes of Cost Allocation  To provide information for decision making  To reduce frivolous use of common resources  To encourage evaluation of services  To provide “full cost” information Slide 6-3Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation Slide 6-4Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation Provide information for decision making  Allocated cost should measure the opportunity cost of using a company resource  In practice, difficult to operationalize since cost may quickly change  Provides a useful benchmark Slide 6-5Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation Reduce frivolous use of common resources  Frivolous use may have hidden cost such as slower service  Allocation of centrally provided services provides incentive for departments to reduce frivolous use of resource Slide 6-6Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation Encourage evaluation of services  If costs are not allocated, there is no incentive to evaluate the services and look for lower cost alternatives  With cost allocation, there is a strong incentive to critically evaluate the efficiency and necessity of services Slide 6-7Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation Provide “full cost” information  GAAP requires full costing for external reporting purposes  Full cost information is needed when the company has an agreement whereby revenue received depends upon cost incurred, i.e.“cost-plus” contracts Slide 6-8Learning objective 1: Explain why indirect costs are allocated

Cost-Plus Contracts Slide 6-9Learning objective 1: Explain why indirect costs are allocated

Process of Cost Allocation  Determine the cost objective  Form cost pools  Select an allocation base to relate cost pools to the cost objective Slide 6-10Learning objective 2: Describe the cost allocation process

Process of Cost Allocation Slide 6-11Learning objective 2: Describe the cost allocation process

Determine the Cost Objective Slide 6-12Learning objective 2: Describe the cost allocation process  Determine the product, service, or department that is to receive the allocation. Object of the allocation is called the cost objective  For example, if computer costs are allocated to contracts, the contracts are the cost objective

Cost Objectives Slide 6-13Learning objective 2: Describe the cost allocation process

In the cost allocation process, the cost objective is the: a.The allocation base used to allocate the costs b.A grouping of individual costs whose total is allocated using one allocation base c.The product, service or department that is to receive the allocation d.None of the above Answer: c The product, service or department that is to receive the allocation Slide 6-14Learning objective 2: Describe the cost allocation process

Form Cost Pools  A grouping of individual costs whose total is allocated using one allocation base  Costs in the pool must be homogeneous (similar)  Cost pools can be organized along -departmental lines, e.g. Maintenance, Personnel depts. -major activities, e.g. equipment setups, inspections. Slide 6-15Learning objective 2: Describe the cost allocation process

Select an Allocation Base  Select an allocation base that relates cost pool to the cost objectives -base must be some characteristic that is common to all of the cost objectives -should be based on cause-and-effect relationship  If indirect costs are fixed, cause-and- effect relationships are difficult to establish and other approaches are used Slide 6-16Learning objective 2: Describe the cost allocation process

Select an Allocation Base  Two production departments: Assembly and Finishing - both receive allocations of indirect costs from the maintenance department - should labor hours or machine hours be used as the allocation base? Slide 6-17Learning objective 2: Describe the cost allocation process

Selecting an Allocation Base Slide 6-18Learning objective 2: Describe the cost allocation process

In the cost allocation process, an allocation base: a.Must be some characteristic that is common to all of the cost objectives b.Ideally should result in cost being allocated based on a cause-and-effect relationship c.Both a and b d.None of the above Answer: c Both a and b Slide 6-19Learning objective 2: Describe the cost allocation process

Fixed Indirect Costs – Other Approaches  Relative benefits approach to allocation - More costs allocated to those objectives that benefit most from incurring the cost  Ability to bear costs - More costs allocated to those that are more profitable  Equity approach to allocation - Base results in allocations that are perceived to be fair or equitable Slide 6-20Learning objective 2: Describe the cost allocation process

Allocating Service Department Costs  Organizational units of manufacturing firms classified as either: - production departments, or - service departments  Cost pools - formed by service departments - Allocated to production departments Slide 6-21Learning objective 3: Discuss allocation of service department costs

Direct Method of Allocating Service Department Costs Service department costs allocated to production departments but not to other service departments Slide 6-22Learning objective 3: Discuss allocation of service department costs

Direct Method – Mason Furniture Slide 6-23  Allocate janitorial cost of $100,000  Allocation base: square feet Assembly Dept: 20,000 square feet Finishing Dept: 30,000 square feet  Calculate Allocation Rate: $100,000 / (20, ,000) = $2/sq ft  Allocation to Production Departments: Assembly Dept.:20,000 sq ft x $2 = $40,000 Finishing Dept.: 30,000 sq ft x $2 = $60,000 Learning objective 3: Discuss allocation of service department costs

Direct Method – Mason Furniture Slide 6-24  Allocate personnel cost of $200,000  Allocation base: number of employees Assembly Dept: 60 employees Finishing Dept: 40 employees  Calculate Allocation Rate: $200,000 / ( ) = $2,000/employee  Allocation to Production Departments Assembly Dept: 60 x $2,000 = $120,000 Finishing Dept: 40 x $2,000 = $80,000 Learning objective 3: Discuss allocation of service department costs

The direct method of allocating costs: a.Allocates service department costs to other service departments b.Allocates only direct costs c.Allocates service department costs to production departments only d.Both b and c Answer: c Allocates service department costs to production departments only Slide 6-25 Learning objective 3: Discuss allocation of service department costs

Direct Method – Mason Furniture Slide 6-26Learning objective 3: Discuss allocation of service department costs

 Three production departments: - Showers - Bathtubs - Vanities  Two service departments: - Mailroom - Janitorial Suggest allocation base for mailroom costs: Number of employees, labor hours, or labor cost Slide 6-27Learning objective 3: Discuss allocation of service department costs

 Three production departments: - Showers - Bathtubs - Vanities  Two service departments: - Mailroom - Janitorial Suggest allocation base for janitorial costs: Square footage, number of work stations Slide 6-28Learning objective 3: Discuss allocation of service department costs

 Three production departments: - Showers: 80 employees - Bathtubs: 40 employees - Vanities: 30 employees  Allocate mailroom costs of $600,000 based on employees  Calculate Allocation Rate: $600,000 / ( ) = $4,000/employee Allocation to Production Departments: Showers: 80 x $4,000 = $320,000 Bathtubs: 40 x $4,000 = $160,000 Vanities: 30 x $4,000 = $120,000 Slide 6-29Learning objective 3: Discuss allocation of service department costs

 Three production departments: - Showers: 1,500 sq ft - Bathtubs: 1,000 sq ft - Vanities: 500 sq ft  Allocate janitorial costs of $90,000 based on sq ft  Calculate Allocation Rate: $90,000 / (1,500+1, ) = $30 per sq ft  Allocate to production departments: Showers : 1,500 x $30 = $45,000 Bathtubs: 1,000 x $30 = $30,000 Vanities : 500 x $30 = $15,000 Slide 6-30Learning objective 3: Discuss allocation of service department costs

Allocating Budgeted and Actual Service Department Costs  Management should allocate based on budgeted costs rather than actual costs  Allocation of actual amounts allows service department to pass on cost of inefficiencies and waste to production departments Slide 6-31Learning objective 3: Discuss allocation of service department costs

Problems with Cost Allocation Potential problems brought about by: 1.Allocations of costs that are not controllable 2.Arbitrary allocations 3.Allocation of fixed costs that make the fixed costs appear to be variable costs 4.Allocations of mfg. overhead to products using too few overhead cost pools 5.Use of only volume related allocation bases Slide 6-32Learning objective 4: Identify potential problems with cost allocation

Responsibility Accounting and Controllable Costs  Responsibility accounting Identifies those responsible for generating revenue and controlling costs  Some cost allocations are not consistent with responsibility accounting - Controllable costs are those under the manager’s control - Some argue that managers should only be allocated controllable costs Slide 6-33Learning objective 4: Identify potential problems with cost allocation

Arbitrary Allocations  Cost allocations are inherently arbitrary  Typically there are numerous allocation bases that are equally justifiable -Managers support the allocation which makes them look best -Managers reject allocations which cast an unfavorable light on their performance Slide 6-34Learning objective 4: Identify potential problems with cost allocation

Unitized Fixed Costs and Lump Sum Allocations  Unitized fixed costs - Fixed costs are stated on a per unit basis and allocated as a variable cost - Perception of costs as variable could alter decision making  Lump-sum allocations - Allocate predetermined amount of fixed costs that is not affected by level of activity - Allocation must appear to be fixed to managers of departments receiving charge Slide 6-35Learning objective 4: Identify potential problems with cost allocation

When fixed costs are stated on a per unit basis: a.Fixed costs are said to be “unitized” b.Fixed costs may appear to be variable to managers receiving allocations c.Decision making is greatly improved d.Both a and b Answer: d Both a and b Slide 6-36Learning objective 4: Identify potential problems with cost allocation

Too Few Cost Pools  Although simple, may lead to distortion of cost allocation, i.e. some products will be overcosted or undercosted  Product costs will be more accurate when more overhead cost pools are used  Must analyze cost-benefit relationship of more cost pools Slide 6-37Learning objective 4: Identify potential problems with cost allocation

Problem of Using Measures of Production Volume to Allocate Overhead Problem of Using Measures of Production Volume to Allocate Overhead  Typical allocation bases include direct labor hours and machine hours  Assumes all overhead costs are proportional to production volume  When OH costs not proportional to production volume: - High-volume products are overcosted - Low-volume products are undercosted Slide 6-38Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Using Only Volume-Related Allocation Bases  Some firms allocate manufacturing overhead based on volume, e.g. direct labor or machine hours  Not all overhead costs vary with volume  Activity-based costing (ABC) solves this problem Slide 6-39Learning objective 4: Identify potential problems with cost allocation

Activity-Based Costing  Identifies major activities that cause overhead costs to be incurred  Cost of resources consumed performing these activities grouped into cost pools  Costs are assigned to products using a measure of activity, i.e. cost driver Slide 6-40Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

The ABC Approach Slide 6-41Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Common Activities and Associated Cost Drivers Slide 6-42Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Activity Based Costing- McMaster Screen Technologies Slide 6-43Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Two cost pools used:  Equipment setups -Total setups = 10,000 -Total cost = $1,500,000  Inspections - Total inspections = $15,000 - Total cost = $3,000,000 Cost per equipment setup: $1,500,000 / 10,000 = $150 per setup Slide 6-44 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Two cost pools used:  Equipment setups - Total setups = 10,000 - Total cost = $1,500,000  Inspections - Total inspections = 15,000 - Total cost = $3,000,000 Cost per inspection: $3,000,000 / 15,000 = $200 per inspection Slide 6-45Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

 Allocation Rates: Equipment setups = $150 per setup Inspections = $200 per inspection  Product cost and activity: Slide 6-46Learning objective 5: Discuss activity- based costing (ABC) and cost drivers Cost/Unit for Product EP150:

 Allocation Rates: Equipment setups = $150 per setup Inspections = $200 per inspection  Product costs and activity: Slide 6-47Learning objective 5: Discuss activity- based costing (ABC) and cost drivers Cost/unit for product EP175:

Benefits of ABC  Provide more accurate costing -Less likely to undercost/overcost due to cost driver usage  May lead to improvements in cost control - Costs broken out into a number of activities rather than into one or two overhead cost pools Slide 6-48 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Limitations of ABC  More costly to develop and maintain than a traditional costing system  Used to develops full cost of products - Includes fixed costs - Lacks incremental information necessary for decision making Slide 6-49 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Fixed and Variable Costs Slide 6-50Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Activity-Based Management  Activity analysis aimed at improving efficiency and effectiveness of business processes  ABC focus is on measuring cost of products and services  ABM focus is on goal of managing the activities themselves Slide 6-51 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

Activity-Based Management Slide 6-52 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

Activity-Based Management  Determine major activities  Identify resources used by each activity  Evaluate the performance of the activities  Identify ways to improve the efficiency and/or effectiveness of the activities Slide 6-53 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

Cost Allocation and Decision Making Slide 6-54 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

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