© The McGraw-Hill Companies, Inc., 2002 Slide 22-1 McGraw-Hill/Irwin 22 Cost Allocation and...

© The McGraw-Hill Companies, Inc., 2002

Slide 22-1

McGraw-Hill/Irwin

22 Cost Allocation and Performance Measurement


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One of the most difficult tasks in

computing accurate unit costs lies in

determining the proper amount of overhead

cost to assign to each job.

Assigningoverhead is

difficult. I agree!

Additional Methods ofOverhead Cost Allocation


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Level of C

omplexity

Level of C

omplexity

Overhead Allocation

Plantwide Overhead

Rate

DepartmentalOverhead

Rates

Activity BasedCosting

Additional Methods ofOverhead Cost Allocation


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A two-stage process maybe used because different

departments may have different allocation bases.

A two-stage process maybe used because different

departments may have different allocation bases.

Finishing Department

Shipping Department

Painting Department

Two-Stage Cost Allocation


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IndirectMaterials

OtherOverhead

IndirectLabor

Department1

Department2

Department3

Stage One:Costs assignedto departments



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IndirectMaterials

OtherOverhead

IndirectLabor

Department1

Department2

Department3


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IndirectMaterials

OtherOverhead

IndirectLabor

Department1

Department2

Department3


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Stage Two:Costs applied

to jobs


Jobs


IndirectMaterials

OtherOverhead

IndirectLabor

Department1

Department2

Department3


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Jobs

Direct Labor Hours

MachineHours

RawMaterials

Cost

Departmental Allocation Bases

Stage Two:Costs applied

to jobs



IndirectMaterials

OtherOverhead

IndirectLabor

Department1

Department2

Department3


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In the ABC method, we recognize that many

activities within a department drive overhead costs.

In the ABC method, we recognize that many

activities within a department drive overhead costs.A

B CA

CB

Activity-Based Costing


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Identify activities and assign indirect costs to those activities.

Central idea . . . Products require activities. Activities consume resources. A

B CA

CB



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More detailed measures of costs.Better understanding of activities.More accurate product costs for . . .

Pricing decisions. Product elimination decisions. Managing activities that cause costs.

Benefits should always be compared to costs of implementation.

Activity-Based Costing Benefits


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Most cost drivers are related to either volume or complexity of production. Examples: machine time, machine setups,

purchase orders, production orders.

Three factors are considered in choosing a cost driver: Causal relationship. Benefits received. Reasonableness.

Identifying Cost Drivers


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Identify activities that consume resources.

Assign costs to a cost pool for each activity.

Identify cost drivers associated with each activity.

Compute overhead rate for each cost pool:

Assign costs to products:

Overhead Actual Rate Activity

×

Rate = Estimated overhead costs in activity cost pool

Estimated number of activity units

Activity-Based Costing Procedures


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Let’s look at anexample comparingtraditional costing

with ABC. We will start with

traditional costing.



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Pear Company manufactures a product in regular and deluxe models. Overhead is assigned on the basis of direct labor hours. Budgeted overhead for the current

year is $2,000,000. Other information:

Deluxe RegularModel Model

Direct Material 150$ 112$ Direct Labor Cost 16 8 Direct Labor Time 1.6 hours 0.8 hoursExpected Volume (units) 5,000 40,000

First, determine the unit cost of each model using traditional costing methods.

Traditional Costing vs. ABCExample


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DirectLabor Hours

Deluxe Model 5,000 units @ 1.6 hours 8,000 Regular Model 40,000 units @ 0.8 hours 32,000

Total Direct Labor Hours (DLH) 40,000

Traditional Costing


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DirectLabor Hours

Deluxe Model 5,000 units @ 1.6 hours 8,000 Regular Model 40,000 units @ 0.8 hours 32,000

Total Direct Labor Hours (DLH) 40,000

Overhead Estimated overhead costs Rate Estimated activity

=

Overhead $2,000,000 Rate 40,000 DLH

= = $50 per DLH

Traditional Costing


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Direct Material 150$ 112$ Direct Labor 16 8 Manufacturing Overhead$50 per hour × 1.6 hours 80 $50 per hour × 0.8 hours 40 Total Unit Cost 246$ 160$

ABC will have differentoverhead per unit.

Traditional Costing


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Pear Company plans to adopt activity-based costing. Using the following activity center data, determine the unit cost of the two products using

activity-based costing.

OverheadActivity Cost Cost for Units of ActivityCenter Driver Activity Deluxe Regular

Purchasing Orders 84,000$ 400 800 Scrap Rework Orders 216,000 300 600 Testing Tests 450,000 4,000 11,000 Machine Related Hours 1,250,000 20,000 30,000 Total Overhead 2,000,000$



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Overhead UnitsActivity Cost Cost for ofCenter Driver Activity Activity Rate

Purchasing Orders 84,000$ 1,200 Scrap Rework Orders 216,000 900 Testing Tests 450,000 15,000 Machine Related Hours 1,250,000 50,000 Total Overhead 2,000,000$

400 deluxe + 800 regular = 1,200 total



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Overhead UnitsActivity Cost Cost for ofCenter Driver Activity Activity Rate

Purchasing Orders 84,000$ 1,200 $ 70 per orderScrap Rework Orders 216,000 900 $240 per orderTesting Tests 450,000 15,000 $ 30 per testMachine Related Hours 1,250,000 50,000 $ 25 per hourTotal Overhead 2,000,000$

Rate = Overhead Cost for Activity ÷ Units of Activity



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Deluxe Model Regular ModelActual Cost Actual Cost

Units of Allocated Units of AllocatedActivity Rate Activity to Product Activity to Product

Purchasing $ 70/order 400 ? 800 ?Scrap Rework $240/order 300 ? 600 ?Testing $ 30/test 4,000 ? 11,000 ?Machine Related $ 25/hour 20,000 ? 30,000 ?Total overhead ? ?



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Purchasing $ 70/order 400 28,000$ 800 56,000$ Scrap Rework $240/order 300 ? 600 ? Testing $ 30/test 4,000 ? 11,000 ? Machine Related $ 25/hour 20,000 ? 30,000 ? Total overhead ? ?

Cost Allocated to Product = Actual Units of Activity × Rate

Let’s completethe table.



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Purchasing $ 70/order 400 28,000$ 800 56,000$ Scrap Rework $240/order 300 72,000 600 144,000 Testing $ 30/test 4,000 120,000 11,000 330,000 Machine Related $ 25/hour 20,000 500,000 30,000 750,000 Total overhead 720,000$ 1,280,000$




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Purchasing $ 70/order 400 28,000$ 800 56,000$ Scrap Rework $240/order 300 72,000 600 144,000 Testing $ 30/test 4,000 120,000 11,000 330,000 Machine Related $ 25/hour 20,000 500,000 30,000 750,000 Total overhead 720,000$ 1,280,000$


Total overhead = $720,000 + $1,280,000 = $2,000,000Recall that $2,000,000 was the original amount of

overhead assigned to the products using traditional overhead costing.



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Overhead Costs Assigned to Products: Deluxe Model $720,000 ÷ 5,000 units = $144 per unit Regular Model $1,280,000 ÷ 40,000 units = $32 per unit


Direct Materials 150$ 112$ Direct Labor 16 8 Manufacturing Overhead 144 32 Total Unit Cost 310$ 152$



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This result is not uncommon when activity-based costing is used. Many companies have found that low-volume, specialized products have greater overhead costs than

previously realized.

Traditional Costing ABCDeluxe Regular Deluxe RegularModel Model Model Model

Direct labor 150$ 112$ 150$ 112$ Direct material 16 8 16 8 Overhead 80 40 144 32 Total cost 246$ 160$ 310$ 152$

Traditional Costing vs. ABC


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Cost Cost DriverMaterials purchasing Number of purchase ordersMaterials handling Number of materials

requisitionsPersonnel processing Number of employees hired

or laid offEquipment depreciation Number of products

produced or hours of useQuality Inspection Number of units inspectedIndirect labor for Number of setups required equipment setupsEngineering costs for Number of modifications product modifications

Exh. 22-6

Costs and Cost Drivers inActivity-Based Costing


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Provide informationfor managers to use

in performanceevaluation.

Provide informationfor managers to use

in performanceevaluation.

Assign costs tomanagers who are

responsible forcontrolling the costs.

Assign costs tomanagers who are

responsible forcontrolling the costs.

Primarygoals

Departmental Accounting


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Large complex businesses are

divided into departments enabling managers to have a

smaller effective span of control.



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Departments areestablished for

specialized functions.


Production Sales Service


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Managers use this information to: Allocate resources.

Control operations.

The accounting system provides information about resources used and outputs achieved. The accounting system provides information about resources used and outputs achieved.

Appraiseperformance

CorrectiveAction

Information forDepartmental Evaluation


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The type of accounting information provided depends on whether the department is a . . .

The type of accounting information provided depends on whether the department is a . . .

Evaluated on ability to

control costs.

Evaluated on ability to

control costs.

Evaluated on abilityto generate revenues

in excess of expenses.

Evaluated on abilityto generate revenues

in excess of expenses.

Costcenter

Profitcenter



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Quality CustomerSatisfaction

ProfitabilityCost

Effectiveness

Information must support these four pillars of

any successful business



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Direct expenses are incurred for the sole benefit of a specific

department.

Indirect expenses benefit more than one department and are

allocated among departments benefited.

Departmental Expense Allocation


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Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments

according to the floor space each occupies.

Square Percent Total AllocatedDepartment Feet of Total Cost CostJewelry 2,400 ? × ? = ?Watch repair 600 ? × ? = ?China and silver 1,000 ? × ? = ?Total 4,000 100%

Exh. 22-7

Illustration of IndirectExpense Allocation


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Square Percent Total AllocatedDepartment Feet of Total Cost CostJewelry 2,400 60% × 300$ = 180$ Watch repair 600 ? × ? = ?China and silver 1,000 ? × ? = ?Total 4,000 100%

Exh. 22-7





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Square Percent Total AllocatedDepartment Feet of Total Cost CostJewelry 2,400 60% × 300$ = 180$ Watch repair 600 15% × 300 = 45 China and silver 1,000 25% × 300 = 75 Total 4,000 100% 300$

Exh. 22-7





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Service Department Common Allocation BasesOffice expenses Number of employeesPersonnel expenses Number of employeesPayroll expenses Number of employeesAdvertising expenses SalesPurchasing costs Number of Purchase OrdersCleaning expenses Floor space occupiedMaintenance expenses Floor space occupied

Service department costs are shared, indirect expenses that support the activities of two or

more production departments.

Exh. 22-8

Bases for AllocatingService Department Costs


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ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly

department has 100 employees and the packing department has 150 employees. What amount of

cost is allocated to assembly?

a. $100,000

b. $120,000

c. $150,000

d. $180,000




a. $100,000

b. $120,000

c. $150,000

d. $180,000

Service Department CostsQuestion


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a. $100,000

b. $120,000

c. $150,000

d. $180,000




a. $100,000

b. $120,000

c. $150,000

d. $180,000

Assembly percentage= 100 ÷ (100 + 150) = 40%

40% of $300,000 = $120,000

Service Department CostsQuestion


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Let’s prepare departmental income statements using the following steps:

Direct expense accumulation.

Indirect expense allocation.

Service department expense allocation.

Preparing DepartmentalIncome Statements


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Service Dept. One

Service Dept. Two

Operating Dept. One

Direct expenses are traced to eachdepartment without allocation.

Operating Dept. Two

Step 1: Direct Expense Accumulation


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Service Dept. One

Service Dept. Two

Operating Dept. One

Operating Dept. Two

Indirect expenses are allocated to all departmentsusing appropriate allocation bases.

Allocation Allocation Allocation Allocation

Step 2: Indirect Expense Allocation


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Operating Dept. One

Operating Dept. Two

Service department total expenses (original direct expenses + allocated indirect expenses) are

allocated to operating departments.

Allocation Allocation

Service Dept. One

Service Dept. Two

Step 3: Service Department Expense Allocation


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Let’s examine this three-step allocation procedure for

Owl Company.

Departmental ExpenseAllocation Spreadsheet


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Expense Allocation to DepartmentsService Service Sales Sales

Allocation Total Dept. Dept. Dept. Dept.Base Expense One Two One Two

Direct expenses Salaries Payroll 20,000$ 1,000$ 2,000$ 6,000$ 11,000$ Supplies Requisitions 1,500 100 300 400 700

Step 1: Direct expenses are traced to service departments and sales departments without allocation.



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Direct expenses Salaries Payroll 20,000$ 1,000$ 2,000$ 6,000$ 11,000$ Supplies Requisitions 1,500 100 300 400 700 Indirect expenses Rent Floor space 10,000 1,000 1,000 3,000 5,000 Utilities Floor space 1,000 100 100 300 500 Total dept. expenses 32,500$ 2,200$ 3,400$ 9,700$ 17,200$

Step 2: Indirect expenses are allocated to both the service and the sales departments based on floor space occupied.

Of a total of 2,000 square feet, the service departments occupy 200 square feet each, sales department one occupies 600 square feet, and sales department two

occupies 1,000 square feet.


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Service dept. expenses Service Dept. One Sales (2,200) 1,000 1,200 Service Dept. Two EmployeesTotal expenses 32,500$ $ 0 3,400$ 10,700$ 18,400$

Sales department one has $40,000 in sales and sales department two has $48,000 in sales.

Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to

sales departments.



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Service dept. expenses Service Dept. One Sales (2,200) 1,000 1,200 Service Dept. Two Employees (3,400) 1,400 2,000 Total expenses 32,500$ $ 0 $ 0 12,100$ 20,400$

Sales department one has 28 employees and sales department two has 40 employees.

Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to

sales departments.


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Service dept. expenses Service Dept. One Sales (2,200) 1,000 1,200 Service Dept. Two Employees (3,400) 1,400 2,000 Total expenses 32,500$ $ 0 $ 0 12,100$ 20,400$



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Now that we have the costs, let’s do an income statement.

DepartmentalIncome Statements


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Sales SalesCombined Dept. One Dept. Two

Sales 88,000$ 40,000$ 48,000$ Cost of goods sold 38,000 20,000 18,000 Gross profit on sales 50,000$ 20,000$ 30,000$ Operating expenses Salaries 17,000$ 6,000$ 11,000$ Supplies 1,100 400 700 Rent 8,000 3,000 5,000 Utilities 800 300 500



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Sales 88,000$ 40,000$ 48,000$ Cost of goods sold 38,000 20,000 18,000 Gross profit on sales 50,000$ 20,000$ 30,000$ Operating expenses Salaries 17,000$ 6,000$ 11,000$ Supplies 1,100 400 700 Rent 8,000 3,000 5,000 Utilities 800 300 500 Service Department One 2,200 1,000 1,200 Service Department Two 3,400 1,400 2,000 Total operating expenses 32,500$ 12,100$ 20,400$ Net Income 17,500$ 7,900$ 9,600$



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Departmental contribution . . . Is used to evaluate departmental performance. Is not a function of arbitrary allocations of indirect

expenses.

A department may be eliminated when its departmental contribution is negative.

Departmental revenue– Direct expenses = Departmental contribution

Departmental revenue– Direct expenses = Departmental contribution

Departmental Contributionto Overhead


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As a general rule, a department canbe considered a candidate for

elimination if its revenues are lessthan its escapable expenses.

Direct expenses are usually escapable. Indirect expenses are usually inescapable.

Eliminating anUnprofitable Department


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Let’s recast Owl Company’s income statement using the departmental

contribution approach where indirect expenses are not allocated.



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Sales 88,000$ 40,000$ 48,000$ Cost of goods sold 38,000 20,000 18,000 Gross profit on sales 50,000$ 20,000$ 30,000$ Direct expenses Salaries 17,000$ 6,000$ 11,000$ Supplies 1,100 400 700 Total direct expenses 18,100$ 6,400$ 11,700$ Departmental Contribution 31,900$ 13,600$ 18,300$ Indirect expenses Rent 8,000 Utilities 800 Service Department One 2,200 Service Department Two 3,400 Total indirect expenses 14,400$ Net Income 17,500$

Net income for the company is

still $17,500.



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Departmental contributions to indirect expenses

(overhead) are emphasized.



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Departmental contributions are positive so neither department is a candidate for elimination.



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Costs are controllableif the manager

has the power to determine, or strongly influence, the amounts

incurred.

A manager’s performance evaluation should be based on controllable

costs.

I’m in control

Controllable Costs


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Direct costs are traced to departments, but may not be controllable by the department manager. Example: Department managers usually

have no control over their own salaries.

Controllable costs are identified with a particular manager and a definite time period. All costs are controllable at some level of management if

the time period is long enough.

Distinguishing Controllableand Direct Costs


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An accounting system thatprovides information . . .

Responsibility Accounting

Relating to theresponsibilities of

individual managers.

To evaluatemanagers on

controllable items.


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Responsibility Accounting Successful implementation of responsibility accounting may use organization charts with

clear lines of authority and clearly defined levels of responsibility.

Successful implementation of responsibility accounting may use organization charts with

clear lines of authority and clearly defined levels of responsibility.

Vice Presidentof F ina nce

D epa rtm ent Ma na ger

Store Ma na ger

V ice Presidentof O pera tions

V ice Presidentof Ma rketing

President

B oa rd of D irectors


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Amount of detail varies according to level in organization.

A department manager receives detailed reports.

A store manager receives summarized information from each department.

Responsibility Accounting Performance Reports


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The vice president of operations receives summarized information

from each store.

Management by exception:

Upper-level management does not receive operating

detail unless problems arise.

Amount of detail varies according to level in organization.



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To be of maximum benefit, responsibility reports should . . . Be timely. Be issued regularly. Be understandable. Compare budgeted

and actual amounts.



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A single cost incurred in producing or purchasing two or more different products. Similar to an indirect expense

since it is shared among morethan one cost object.

Example: The cost of crudeoil is a joint cost for manypetrochemical products.

Joint Costs


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Jointcosts


If we allocate the joint costs of raising the animal to the two products based on weight, which product

would receive the largest cost allocation?

Allocating Joint Costs

Hamburger, because there is more of it.


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If we allocate the joint costs of raising the animal to the two products based on sales value, would the

steak receive a greater portion of the cost allocation?

Allocating Joint Costs

Yes, steak has a higher sales value than hamburger.

Jointcosts



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Allocate the $200,000 joint cost based on sales value.

Product OneSales value = $80,000

Product TwoSales value = $200,000

Product ThreeSales value = $120,000

$200,000Joint Cost

Allocating Joint Costson a Value Basis


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Percent Joint AllocatedProduct Value of Total Cost CostOne 80,000$ 20% × 200,000$ = 40,000$ Two 200,000 50% × 200,000 = 100,000 Three 120,000 30% × 200,000 = 60,000

Total 400,000$ 100% 200,000$

Allocating Joint Costson a Value Basis


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End of Chapter 22

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