Prepared by Debby Bloom-Hill CMA, CFM

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  When managers use a company resource they are receiving a charge for use  Allocated cost should measure the opportunity cost of using a company resource  Provides a useful benchmark  The closer to the opportunity cost of use, the better the allocation Slide 6-5Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation  To reduce frivolous use of common resources  When managers are not charged for a service, they may tend to use it for frivolous or nonessential purposes  Frivolous use may have hidden cost such as slower service  Allocation provides incentive for departments to reduce frivolous use Slide 6-6Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation  To 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  Users will certainly bring lower cost alternatives to the company’s attention Slide 6-7Learning objective 1: Explain why indirect costs are allocated

Purposes of Cost Allocation  To 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  Also called “cost-plus” contracts Slide 6-8Learning objective 1: Explain why indirect costs are allocated

All of the following are reasons indirect costs are allocated to products, services and departments, except: a.To improve decision making b.To reduce frivolous use of resources c.To provide information on variable and fixed costs d.To encourage evaluation of services Answer: c Indirect costs are allocated to provide full cost information Slide 6-9Learning objective 1: Explain why indirect costs are allocated

Cost-Plus Contracts Slide 6-10Learning objective 1: Explain why indirect costs are allocated

Process of Cost Allocation  Cost allocation is achieved by a three step process 1.Determine the cost objective 2.Form cost pools 3.Select an allocation base to relate cost pools to the cost objective Slide 6-11Learning objective 2: Describe the cost allocation process

Slide 6-12Learning objective 2: Describe the cost allocation process  Step 1 – determine the cost objective  Determine the product, service, or department that is to receive the allocation  The object of the allocation is referred to as the cost objective  For example, if computer costs are allocated to contracts worked on, the contracts are the cost objectives Process of Cost Allocation

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

Slide 6-14Learning objective 2: Describe the cost allocation process Process of Cost Allocation

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 6-15Learning objective 2: Describe the cost allocation process

 Step 2 – form cost pools  A cost pool is a grouping of individual costs whose total is allocated using one allocation base  Cost pools can be organized along departmental lines or major activities, e.g. equipment setups, inspections.  Costs in the pool must be homogeneous (similar) Slide 6-16Learning objective 2: Describe the cost allocation process Process of Cost Allocation

 Step 3 – select an allocation base that relates the cost pool to the cost objectives  The base must be some characteristic that is common to all of the cost objectives  Deciding which base to use is not easy  The allocation should be based on a cause-and- effect relationship  Establishing cause-and-effect relationships is not feasible when indirect costs are fixed  Accountants use other methods which are shown on the next slide Slide 6-17Learning objective 2: Describe the cost allocation process Process of Cost Allocation

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 products, services or departments that are more profitable  Equity approach to allocation  Base results in allocations that are perceived to be fair or equitable Slide 6-18Learning 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 6-19Learning objective 2: Describe the cost allocation process

Selecting an Allocation Base Slide 6-20Learning 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 6-21Learning objective 2: Describe the cost allocation process

Allocating Service Department Costs  Organizational units of manufacturing firms classified as either:  Production departments  Engage in direct manufacturing activity  Service departments  Provide indirect support  Cost pools  Formed by service departments  Allocated to production 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 department: 20,000 square feet Finishing department: 30,000 square feet  Calculate the 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 department: 60 employees Finishing department: 40 employees  Calculate the 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

Direct Method of Allocating Service Department Costs Service department costs allocated to production departments but not to other service departments Slide 6-25Learning 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 6-26 Learning objective 3: Discuss allocation of service department costs

Direct Method – Mason Furniture Slide 6-27Learning objective 3: Discuss allocation of service department costs

Slide 6-28Learning objective 3: Discuss allocation of service department costs

Taylor Bath has three production departments and allocates mailroom costs of $600,000 based on number of employees  Showers: 80 employees  Bathtubs: 40 employees  Vanities: 30 employees Use the allocation rate of $4,000 per employee to allocate the mailroom costs to showers, bathtubs and vanities Showers 80 employees * $4,000 rate = $320,000 Bathtubs 40 employees * $4,000 rate = $160,000 Vanities 30 employees * $4,000 rate = $120,000 Slide 6-29Learning objective 3: Discuss allocation of service department costs

Allocating Budgeted and Actual Service Department Costs  Management should allocate based on budgeted rather than actual costs  Allocation of actual amounts allows service department to pass on cost of inefficiencies and waste to production departments Slide 6-30Learning objective 3: Discuss allocation of service department costs

Problems with Cost Allocation Potential problems are 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 manufacturing overhead to products using too few overhead cost pools 5.Use of only volume-related allocation bases Slide 6-31Learning objective 4: Identify potential problems with cost allocation

Responsibility Accounting and Controllable Costs  One of the primary uses of managerial accounting is to evaluate the performance of managers and the operations under their control  Evaluation is facilitated by a system which traces revenues and costs to units with related responsibility for generating revenue and controlling costs  This system is referred to as a responsibility accounting system Slide 6-32Learning objective 4: Identify potential problems with cost allocation

Responsibility Accounting and Controllable Costs  Cost allocation is generally required in a responsibility accounting system  One unit is often responsible for the costs incurred by another unit  Some allocations are not consistent with a responsibility accounting system  Managers should be held responsible for controllable costs only  Controllable costs are affected by a manager’s decisions 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  In almost all situations, determining the true allocation is impossible  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  The allocation process may make fixed costs appear to be variable costs  This happens when fixed costs are unitized  Unitized fixed costs are stated on a per unit basis  When managers increase sales they also increase their allocated general and administrative costs  This could lead to decisions which could hurt the profitability of the company Slide 6-35Learning objective 4: Identify potential problems with cost allocation

Lump Sum Allocations  Allocations of fixed costs can be made that they appear fixed to managers  This is achieved by lump-sum allocations of fixed costs  A lump-sum allocation is not affected by changes in the activity level of the organizational unit  Lump-sum allocations generally should remain the same from year to year Slide 6-36Learning 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 controllable b.Fixed costs may appear to be variable to managers receiving allocations c.A lump-sum allocation has been made d.Divisions with high sales receive a low amount of allocated costs Answer: b Fixed costs may appear to be variable to managers receiving allocations Slide 6-37Learning objective 4: Identify potential problems with cost allocation

Too Few Cost Pools  Some companies assign overhead to products using only one or two overhead cost pools  Although simple, this may lead to distortion of cost allocation  Some products will be overcosted  Some products will be undercosted  This problem is solved by setting up separate cost pools for overhead Slide 6-38Learning objective 4: Identify potential problems with cost allocation

 Product costs will be more accurate when more overhead cost pools are used  Decisions that rely on product cost information will be improved  However, more cost pools equals more expensive record keeping  Must analyze cost-benefit relationship of more cost pools Slide 6-39Learning objective 5: Discuss activity-based costing (ABC) and cost drivers Too Few Cost Pools

Using Only Volume-Related Allocation Bases  Some firms allocate manufacturing overhead based on volume, using allocation bases like  Direct labor hours, or  Machine hours  Not all overhead costs vary with volume  Referred to as the traditional approach Slide 6-40Learning objective 4: Identify potential problems with cost allocation

Using Only Volume-Related Allocation Bases  The problem with the traditional approach is that it assumes that all overhead costs are proportional to production volume  Many overhead costs are not proportional to volume  The cost of setting up equipment for a production run  The cost of inspecting raw materials  Among others Slide 6-41Learning objective 4: Identify potential problems with cost allocation

Which of the following is not a volume- related cost driver? a.Direct labor hours b.Direct labor cost c.Machine time d.Time to set up a production run Answer: d A production run will take the same amount of time to set up no matter how many units are in the production run Slide 6-42Learning objective 4: Identify potential problems with cost allocation

Activity-Based Costing (ABC)  Using the ABC approach, companies identify major activities that cause overhead costs to be incurred  Some activities are related to production volume, some are not  The cost of resources consumed performing these activities are grouped into cost pools  Costs are assigned to products using a measure of activity referred to as a cost driver Slide 6-43Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

The ABC Approach Slide 6-44Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Relating Cost Pools to Products Using Cost Drivers Slide 6-45Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Common Activities and Associated Cost Drivers Slide 6-46Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

 McMaster Screen Technologies has two products and allocates overhead costs using a rate of $4 per dollar of labor.  One product has a very low gross profit and the other has a very high gross profit  The CFO suspects that this may be due to problems with the costing system  The CFO authorizes a study of how product costs will change if an ABC approach is taken Slide 6-47Learning objective 5: Discuss activity-based costing (ABC) and cost drivers Activity Based Costing- McMaster Screen Technologies

 The study finds that overhead cost is related to 7 drivers shown on the next slide  The ABC approach reveals that the high- volume product is very profitable  However, the selling price does not come close to covering the full cost of the low volume product  The CFO’s intuition that the traditional product costing might be providing misleading information is correct Slide 6-48Learning objective 5: Discuss activity-based costing (ABC) and cost drivers Activity Based Costing- McMaster Screen Technologies

Slide 6-49Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Power Electronics uses two cost pools  Equipment setups  Total estimated cost $1,500,000  Estimated setups 10,000  Inspections  Total estimated cost $3,000,000  Estimated inspections 15,000 Calculate the cost per driver unit for each pool Equipment setups $1,500,000 / 10,000 = $150 per setup Inspections $3,000,000 / 15,000 = $200 per inspection Slide 6-50 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Power Electronics has two products:  EP150  10 setups  3 inspections  EP175  40 setups  8 inspections Calculate the overhead applied to EP150 Equipment setups 10 * $150 per setup = $1,500 Inspections 3 * $200 per inspection = $600 Total overhead $1,500 + $600 = $2,100 Slide 6-51 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Power Electronics has two products:  EP150  10 setups  3 inspections  EP175  40 setups  8 inspections Calculate the overhead applied to EP175 Equipment setups 40 * $150 per setup = $6,000 Inspections 8 * $200 per inspection = $1,600 Total overhead $6,000 + $1,600 = $7,600 Slide 6-52 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Pros and Cons of ABC  Benefits  Less likely to undercost complex low volume products and overcost simple high volume products  Drivers used in ABC are not always volume related  ABC may lead to improvements in cost control  Costs are not buried in one or two pools Slide 6-53 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Pros and Cons of ABC  Limitations  More costly to develop and maintain than a traditional costing system  Allocations are made from each cost pool to each product  Used to develop full cost of products  Includes fixed costs  Lacks incremental information necessary for decision making Slide 6-54 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Fixed and Variable Costs Slide 6-55Learning objective 5: Discuss activity-based costing (ABC) and cost drivers

Activity-Based Management  A tool that involves analyzing and costing activities with the goal of improving efficiency and effectiveness  ABC focus is on measuring cost of products and services  ABM focus is on goal of managing the activities themselves  For example, ABC would calculate the cost per equipment setup  ABM would focus on ways to improve the setup process and reduce setup cost Slide 6-56 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

Activity-Based Management Slide 6-57 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

Cost Allocation and Decision Making Slide 6-58 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

AppendixAppendix  The steps in activity-based management are: 1.Determine major activities 2.Identify resources used by each activity 3.Evaluate the performance of the activities 4.Identify ways to improve the efficiency and/or effectiveness of the activities Slide 6-59 Learning objective 6: Distinguish activity-based costing (ABC) from activity-based management (ABM)

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