mcgraw-hill/irwin © the mcgraw-hill companies, inc., 2005 21-1 cost allocation and performance...

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

21-1

Cost Allocation and Performance Measurement

Chapter

2121Modified from Publisher Provided Slides


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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!

Overhead Cost Allocation MethodsOverhead Cost Allocation Methods


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Level of C

omplexity

Level of C

omplexity

Overhead Allocation

Plantwide Overhead

Rate

DepartmentalOverhead

Rates

Activity BasedCosting

Activity-Based Cost AllocationActivity-Based Cost Allocation


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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 CACB

Activity-Based Cost AllocationActivity-Based Cost Allocation


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Identify activities and assign indirect costs to those activities.

Central idea . . .• Products require activities.

• Activities consume resources. A

B CACB

Activity-Based CostingActivity-Based Costing


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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 comparedto costs of implementation.

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 comparedto costs of implementation.

Activity-Based Costing BenefitsActivity-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.

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 DriversIdentifying 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 ProceduresActivity-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:

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

Traditional Costing vs. ABCExampleTraditional Costing vs. ABCExample


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Traditional CostingTraditional Costing

Overhead Estimated overhead costs Rate Estimated activity

=

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

= = $50 per DLH


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Deluxe RegularModel Model

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 CostingTraditional 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.



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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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Let’s completethe table.



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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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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. ABCTraditional 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

Costs and Cost Drivers inActivity-Based CostingCosts and Cost Drivers inActivity-Based Costing Exh.

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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 AllocationDepartmental 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.

Illustration of IndirectExpense AllocationIllustration of IndirectExpense Allocation Exh.

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

more production departments.

Bases for AllocatingService Department CostsBases for AllocatingService Department Costs Exh.

21-8


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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. $100,000b. $120,000c. $150,000d. $180,000




Service Department CostsQuestionService Department CostsQuestion


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

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

Service Department CostsQuestionService 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 StatementsPreparing 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 AccumulationStep 1: Direct Expense Accumulation


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Service Dept. One

Service Dept. Two

Operating Dept. One

Indirect expenses are allocated to all departmentsusing appropriate allocation bases.

Allocation Allocation Allocation Allocation

Step 2: Indirect Expense AllocationStep 2: Indirect Expense Allocation

Operating Dept. Two


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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 AllocationStep 3: Service Department Expense Allocation


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Let’s examine this three-step allocation procedure for

Owl Company.

Departmental ExpenseAllocation SpreadsheetDepartmental 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 StatementsDepartmentalIncome 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 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 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 OverheadDepartmental 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 DepartmentEliminating 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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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 CostsControllable 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 CostsDistinguishing Controllableand Direct Costs


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An accounting system thatprovides information . . .

Responsibility AccountingResponsibility 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 inance

D epartm ent M anager

Store M anager

V ice Presidentof O perations

V ice Presidentof M arketing

President

B oard 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 AccountingPerformance ReportsResponsibility AccountingPerformance 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.

Responsibility AccountingPerformance ReportsResponsibility AccountingPerformance Reports


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End of Chapter 21End of Chapter 21

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