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Module 5: Activity-based costing and service department costing

Required readings

● Chapter 5, pages 172-195● Appendix 4B, pages 152-156● Reading 5-1 “Allocating costs by Behaviour”

Overview

This module explains the merits and application of activity-based costing and service department costing. It covers the activity-based costing system in depth, beginning with the initial design of the system followed by an illustration of its application. The module also explains the allocation of overhead costs incurred by service department.

Computer illustrations 5.4-1 and 5.6-1 demonstrate the use of spreadsheet program worksheets to (1) allocate overhead costs using activity-based costing and (2) calculate allocation of service department costs by two different methods.

Assignment reminder

Assignment 1 is due this week. Be sure to allocate sufficient time to complete and submit the assignment by the deadline.

Assignment 2 (see Module 7) is due at the end of week 7 (see Course Schedule). It is a good idea to take a look at it now in order to familiarize yourself with the requirements as you work through the next three modules.

Topic outline and learning objectives

5.1 Overhead costing in the new manufacturing environment

Describe activity-based costing, and explain how it differs from a traditional costing system. (Level 1)

5.2 Design of an activity-based costing system

Assign overhead costs using activity-based costing. (Level 1)

5.3 Comparison of traditional and ABC product costs

List the benefits and limitations of activity-based costing. (Level 2)

5.4 Computer illustration 5.4-1: Activity-based costing

Design a worksheet to compare the effects of allocating manufacturing overhead based on direct labour-hours and activities performed. (Level 1)

5.5 Guidelines for service department cost allocation

Allocate fixed and variable service department costs to other departments using the direct method, the step method, and the reciprocal method. (Level 1)

5.6 Computer illustration 5.6-1: Step method and direct method of cost allocation

Calculate and compare the allocation of costs using the step method and the direct method, and explain the differences between the two methods. (Level 1)

Module summary

Print this module

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Management Accounting Fundamentals Reading 5-1 . 1

2 . Reading 5-1 Management Accounting Fundamentals


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5.1 Overhead costing in the new manufacturing environment

Learning objective

● Describe activity-based costing, and explain how it differs from a traditional costing system. (Level 1)

LEVEL 1

Module 2 demonstrates the application of a predetermined overhead rate in calculating the cost of a product under a job-order costing system. Usually, a single rate is used for all overhead costs, based on either direct labour-hours or machine-hours.

With the increasing level of automation in many industries today, total overhead costs have increased substantially to the point where they often represent a large portion of total product costs. This increase has created a need to take a closer look at the accuracy of the allocation of overhead cost to product cost. When overhead is allocated inaccurately, product prices or contract bids are calculated based on incorrect cost. This could result in a company selling or bidding too low or losing a contract by bidding too high. The increase in business that could result from bidding low is good in the short run. In the long run, however, costs are not recovered in proportion to amounts incurred and this could result in unexpected losses. Owners want stable or increasing profit percentages, but contracts that are lost because pricing is too high could trigger a decline in demand and therefore a loss in profit opportunity.

Overhead rates

The objective of overhead allocation is to approximate what actual overhead charges would be if they were traced more precisely, that is, traced as a direct cost. The allocation should be fair and equitable to the recipient based on the benefits received by the recipient. For example, if the costs of the personnel department are to be charged to jobs or processes, they should be allocated on the basis of who used the services of the department. But on what basis should the costs be allocated — prorata based on payroll costs in the recipient department, on the number of employees in the recipient department, or on the number of new employees hired?

To achieve a fair and equitable allocation, it is necessary to determine what drives the cost of the providing department, that is, what causes the cost of the personnel department to increase or decrease from one period to the next. Then the cost should be allocated based on the consumption of the activity that drives the cost. Different rates could be applied for different activities. More than one rate may be used in each department.

If operations are the same in every department, manager may use a plantwide overhead rate. As you learned in Topic 2.3, this means that the company has only one overhead rate for every type of product and process in the operation.

There are often differences between departments. For example, one department may be very labour intensive and another department may be completely automated. If the company uses a plantwide rate based on direct labour-hours, the second department will not be charged any overhead. Departmental overhead rates charge overhead based on the specific functions of the department. For example, machine-hours may be a more accurate basis for the amount of overhead that the second department should be charged.

This broadly addresses the differences in how work is carried out in various departments. However, it is a simplified approach to allocating overhead because it is based on the assumption that all overhead costs are driven by a single cost driver in the department. In organizations that produce a single product or homogenous products that use up similar amounts of resources, the plantwide and departmental methods of overhead application can be effective. In organizations that produce a variety of products that use dissimilar amounts of resources, using plantwide or departmental rates may result in incorrect product costing.

A third method of charging overhead focuses on a company's functions or activities instead of departments. This method is called activity-based costing (ABC).

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5.2 Design of an activity-based costing system

Learning objective

● Assign overhead costs using activity-based costing. (Level 1)

LEVEL 1

The activity-based costing (ABC) system assigns overhead costs based on the amount of overhead each product consumes or causes. Some overhead costs are related to the volume of units produced. Other overhead costs are related to factors such as machine setups, change orders, inspections, and so on. Therefore, to accurately allocate overhead costs, it is necessary to first understand the activities involved in the process and then allocate costs based on consumption of the activities.

The textbook uses a five-step process for developing an activity-based costing system:

● Step 1 identifies all activities involved in producing a product or providing a service. The activities are grouped into manageable segments called activity centres. The number of centres should be sufficient to explain all variations in overhead costs. Some overhead costs vary by volume of units produced; other costs vary by the number of batches produced, the number of different products, and so on. Thus, the activity centres should be segregated on the basis of five different activity levels — unit level, batch level, product level, customer-level, and organization-sustaining level (explained on page 175). Exhibit 5-8 shows examples of activity centres found at each of the levels. Measures are also identified in this step. A measure is really the driver that causes the cost to increase in the activity cost pool. The amount of overhead allocated to the cost pool is determined by this measure. The bottom of page 178 provides some examples of activity measures.

● Step 2 assigns costs of the activities to these activity centres (commonly referred to as cost pools).

● Step 3 calculates activity rates. These rates are the dollar values used to assign the overhead costs to products and customers.

● Step 4 uses the cost drivers to allocate the overhead costs from the cost pools to the specific products or services using the activity rate. There should be a high degree of correlation between the cost driver and the actual consumption of overhead to obtain an accurate allocation of the overhead costs.

● Step 5 prepares management reports.



5.3 Comparison of traditional and ABC product costs

Learning objective

● List the benefits and limitations of activity-based costing. (Level 2)

LEVEL 2

While there are many benefits to using ABC, the system has some limitations as well. These benefits and limitations are summarized in the text on pages 188-195. Whether ABC should be adopted by a particular organization depends on the situation.

Here are two fundamental requirements that must be met before an ABC system can be considered for adoption:

● The consumption ratios of unit-based and non-unit-based activities must differ.

● The non-unit-based costs should be a significant percentage of total overhead costs.

The benefits of the ABC system must exceed the costs of setting up the system. Cost considerations should include both the cost of measurement (costs associated with the measurements required by the system) and the cost of errors (costs associated with making poor decisions based on inaccurate product costs).

Implementing an ABC system is usually advisable when measurement costs are low, competition is fierce, and product diversity is high.

Chapter summary

This topic marks the end of the textbook coverage of activity-based costing. To ensure you understand this material and the corresponding terminology, read the summary on page 195, and work through the review problem on pages 196-197.



5.4 Computer illustration 5.4-1: Activity-based costing

Learning objective

● Design a worksheet to compare the effects of allocating manufacturing overhead based on direct labour-hours and activities performed. (Level 1)

LEVEL 1

Material provided

● A partially completed worksheet M5P1, which you will complete. ● A completed solution worksheet M5P1S, to which you can compare your work.

Required

Using the worksheet M5P1, complete Requirements 1 and 3b of Problem 5-24 on pages 220-221 of the textbook by entering the appropriate formulas in rows 24 to 29.

Procedure

Perform the following steps:

1. Open the file MA1M5P1.

2. Move the cell pointer to row 7. The range A5 to F20 comprises the data table. The relevant data from the problem have been reproduced here to minimize data input.

3. Move the cell pointer to row 21. You will be required to complete the template contained in the range A21 to F31 in order to answer Requirements 1 and 3b. Requirement 2 has been calculated for you, and the result appears in cells F15 to F18.

Requirement 1

1. Using the information from the data table, enter in cell B24 the formula that will allow you to calculate the predetermined overhead rate using direct labour-hours as a base.

2. Complete the schedule in the range B27 to C29 by entering the required formulas. Note that row 30 already contains the required formulas.

Requirement 3b

1. Using the information contained in the data table, enter the required formulas in the range E27 to F29 to calculate the cost of production under the activity-based method.

2. Save a copy of your worksheet.

3. Print a copy of your worksheet.

4. Click the sheet tab M5P1S for the solution. Compare your printout with the solution. If you do not have the same results, print a copy of the formulas of your worksheet and compare them with the formulas of the solution worksheet. Correct any errors.

Conclusion

Unit costs appear to be distorted as a result of using direct labour-hours as a base in assigning overhead cost to products.


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Although the deluxe model requires twice as much labour time as the regular model, it is still not being assigned enough overhead cost.

When the company’s overhead costs are analyzed on a transaction basis, it becomes obvious that the deluxe model is very expensive to manufacture compared to the regular model. The deluxe model accounts for 41% of the machine-related costs, even though it accounts for only 11% of the company’s total production. Also, it accounts for 56% of the scrap/rework orders, which are very costly to the company, and 40% of the product testing.

When activity-based accounting is used and the company’s transactions are analyzed by product, the overhead cost jumps from $80 per unit for the deluxe model to $165.60 per unit. This fact suggests that insufficient overhead cost is being assigned to the deluxe model. If these costs are being used as a basis for pricing, the selling price for the deluxe model is too low. This may be the reason why profits have been steadily declining over the last several years. It may also be the reason why sales of the deluxe model have been increasing rapidly.


5.5 Guidelines for service department cost allocation

Learning objective

● Allocate fixed and variable service department costs to other departments using the direct method, the step method, and the reciprocal method. (Level 1)

LEVEL 1

IAS 2 paragraph 12 (related to inventory valuation), requires a “systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.” Producing and operating department costs are allocated to products that pass through them. Service department costs are also part of overhead and should be included in the cost of the product. Since no products pass through service departments, their costs must first be allocated to production departments and then in turn to products passing through those departments, as is done with other overhead costs.

In a nonmanufacturing situation, services are provided to operating departments; otherwise, the process is similar to that used by manufacturers.

The basic areas of concern in allocating service department costs: are selecting the proper allocation base and deciding what to do about interdepartmental (that is, reciprocal) services. Should costs be allocated by the direct method, the step method, or the reciprocal method?

The process of cost allocation can be complex and should take into account the difficulties of arbitrary allocation procedures. Nevertheless, cost must be allocated for financial reporting purposes. When there is no "true" or "best" allocation procedure, the simplest one may be the most appropriate. Allocation bases are usually physical, which means that the allocation is done in physical rather than value terms. The illustration on page 153 uses employee hours as a base for allocating hospital administration costs and space occupied in square metres for allocating custodial services. Other allocation bases could be machine-hours for the maintenance department and volume handled for materials handling.

Once an allocation base has been selected, managers determine the method of allocating between service departments.

Methods of cost allocation

The textbook discusses three methods that can be used to allocate service department costs to operating departments. The direct method ignores inter-service department work and allocates all service department costs directly to operating departments. The step method assumes the service goes in one direction only, and sequentially allocates a department’s costs to other service departments and to operating departments. Exhibits A-4-11 and 4-13 (Appendix 4B) illustrate these approaches. Work through each example carefully.

The “Step-Down Method” section on page 154 states that the sequence of allocation of service department costs is based on the amount of service provided to other departments, with the department providing the greatest level of service (based on activity level) being allocated first, followed by the next greatest. However, the actual example in the text does not follow that method. Rather it uses a second method, which is the allocation sequence based on the greatest amount of costs to allocate with the highest amount being first (also valid).

Note: In practice, either method can be used. In examinations and assignments, use the allocation sequence based on the amount of service provided to other service departments unless the question specifies the order to use.

The reciprocal method yields more precise results than the step method in cases where service departments work for one another as well as for producing or operating departments. While the step method allocates costs only forward and not backward, the reciprocal method allocates costs in both directions. Exhibit 4-14 illustrates the reciprocal method.

Activity 5.5-1 Allocation of service department costs

Work through this activity to help you understand the development and application of multiple overhead rates when there is



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more than one cost driver.

Allocating costs by behaviour

The previous discussion focused on allocating service department resources using a single allocation base. This is the simplest approach to applying these costs to operating departments. Another option, discussed in Reading 5-1, is to first separate the costs by behavior and then apply costs to the operating departments to fairly represent the operating department manager’s ability to control those costs. For purposes of responsibility accounting (introduced in Module 8) this approach provides a more effective basis for evaluating management performance.

Using this approach, variable costs of the service department are applied based on the operating department’s use of the service. Variable cost per unit should be a rate that is predetermined based on budgeted costs of the service department. Managers of operating departments should only be responsible for their use of the service, not for the inefficiencies of the service department. When allocating fixed costs, it is important to take into consideration how the actions of one department affect the service department cost amount that is allocated to others. If fixed costs are allocated based on the operating department's use of the service department, an operating department can be unfairly charged with additional overhead if other departments use less resources than originally budgeted. (An example of this is provided on page 750 of Reading 5-1.) This potential loss of control should be taken into consideration when allocating costs for purposes of assessing responsibility. These costs should be allocated on a predetermined basis using budgeted amounts that reflect the capacity of the consuming (operating) departments. Allocated service department costs are included in the responsibility reports of the operating departments, as shown in Exhibit A-7 on page 749 of Reading 5-1. At this point, do not be concerned about the preparation of a flexible budget; simply note that the budget of the operating departments includes overhead costs allocated from the service departments. (The flexible budget and variance analysis are covered in more detail in Modules 6 and 7.) As discussed in Module 2, when using a normal costing system, these predetermined costs would also be included as part of the budgeted manufacturing overhead costs, and used to determine the overhead application rate.

Ensure that you understand the guidelines for allocating service department costs. Especially note the cautions outlined on pages 750 to 751. In addition to differentiating between fixed and variable costs, this section warns of the use of sales dollars as an allocation base. Sales dollars should be used as a base to allocate a service department’s costs only if there is a causal relationship between sales dollars and the service provided.

Chapter summary

This topic marks the end of the textbook coverage of service department costing. To ensure you understand this material and the corresponding terminology, read the summary on page 752, work through the review problems on pages 753-754.


5.6 Computer illustration 5.6-1: Step method and direct method of cost allocation

Learning objective

● Calculate and compare the allocation of costs using the step method and the direct method, and explain the differences between the two methods. (Level 1)

LEVEL 1

Computer illustration 5.6-1 demonstrates how you would use a spreadsheet program to construct a worksheet to calculate the allocation of service department costs using (a) the step method and (b) the direct method of cost allocation.

Material provided

● A partially completed worksheet M5P2, which you will complete.● A completed solution worksheet M5P2S, to which you can compare your work.

Required

Interdepartmental cost allocations can be calculated using the step method, the direct method, and the reciprocal method. Appendix 4B of the text explains these methods. This computer illustration demonstrates how you can construct a cost allocation worksheet to perform cost allocations using the step method and the direct method. You should first read pages 152-156 and study Exhibits 4-11 and 4-13 carefully. Then use the following procedure to complete the worksheet.

Procedure

1. Open the file MA1M5P2.

2. Study the structure of the worksheet. Notice that the worksheet is set up to resemble Exhibits 4-11 and 4-13. The data table is in rows 5 to 14. Calculations for the step method of cost allocation are located in rows 16 to 28; calculations for the direct method are in rows 31 to 43. The worksheet is designed so that you can move between the three areas (data table, step method, and direct method) by pressing PGUP and PGDN. The allocation of overheads for hospital administration and custodial services is based on labour-hours and space occupied, respectively, as shown in Exhibits 4-11 and 4-13.

3. Move to row 25 and examine the formulas that calculate the allocation of hospital administration costs based on labour-hours. After you have examined these formulas and understood the techniques used, move to cells C26, D26, E26, and F28 and note that these cells are empty. Enter the appropriate formulas in these cells, using space occupied as the basis of allocation. Compare the results with Exhibit 4-13. Correct your formulas if your worksheet does not show the same results.

4. In a similar manner, examine the formulas used in the direct method (rows 31 to 43). Examine carefully the formulas in row 41, which calculate the allocation of custodial services costs. Next move the cell pointer to row 40 and notice that cells D40 and E40 are empty. Notice also that cell F43 is empty. Enter the appropriate formulas in these cells. Compare the results with Exhibit 4-11. Correct your formulas if your worksheet does not show the same results.

5. Save the completed worksheet. If your results do not match Exhibits 4-11 and 4-13, follow steps 6 and 7. Otherwise, go to step 8.

6. Print a copy of the formulas in the range B21 to F43.

7. Click the sheet tab M5P2S and compare the solution with your printout from step 6. Correct any errors.

8. Use the solution worksheet M5P2S to perform the following what-if analysis:

What if:




1. the hospital administration cost to be allocated is $420,000?2. the hospital administration cost is $420,000, and the custodial services cost is $94,000?

Run these two situations through the solution worksheet. You should obtain the following results:

Total costs after allocations Laboratory Daily patient careCase a: Step method: $ 414,667 $1,045,333 Direct method: $ 427,500 $ 1,032,500 Case b: Step method: $ 415,067 $ 1,048,933 Direct method: $ 427,900 $ 1,036,100

From the results, you can see the ease with which sensitivity analysis can be performed using spreadsheets.


Module 5 summary

On the one hand, Module 5 consists of activity-based costing (ABC), and on the other hand, it discusses the treatment of costs of service departments.

ABC is a response to many weaknesses of traditional cost accounting especially with regard to overhead costs. Topic 5.1 contrasts ABC with the traditional uses of plant-wide and departmental overhead rates.

Since the activities link overhead costs to cost objects, Topic 5.2 traces overhead resources consumed to the concerned cost objects.

Topic 5.3 goes beyond a simple comparison of traditional costing and ABC in that it also evaluates the ABC method, sets out the fundamental requirements to its implementation, and discusses the situations where the method is appropriate.

Topic 5.4 brings out the cost distortions as a result of the use of traditional costing methods while ABC gives a more realistic and accurate picture of product costs.

Although not involved directly in product or operating activities, the costs incurred by service departments are crucial to organizations. Topic 5.5 deals with the methods of allocation of these costs to manufacturing or operating departments.

Finally, Topic 5.6 discusses two allocation methods of service department costs and conducts a sensitivity analysis pertaining thereto.

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