prepared by debby bloom-hill cma, cfm. chapter 6 cost allocation & activity-based costing cost...

Prepared by Debby Bloom-Hill CMA, CFM

CHAPTER 6

Cost Allocation &Activity-Based Costing

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, describe the cost allocation process, and discuss allocation of service department costs.

Purposes of Cost Allocation


Purposes of Cost Allocation To 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


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 purposesFrivolous use may have hidden costs

such as slower service Allocation provides incentive for

departments to reduce frivolous use


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


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


All of the following are reasons indirect costs are allocated to products, services and departments, except:

a. To improve decision makingb. To reduce frivolous use of resourcesc. To provide information on variable and

fixed costsd. To encourage evaluation of services

Answer: c The allocation of indirect costs does not provide information on variable and fixed costs


Cost-Plus Contracts


Process of Cost Allocation

Cost allocation is achieved by a three step process1. Determining the cost objective2. Forming cost pools3. Selection of an allocation base to

relate cost pools to the cost objective


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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


Learning objective 1: Explain why indirect costs are allocated, describe the cost allocation process, and discuss allocation of service department costs.

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In the cost allocation process, the cost objective is the:

a. The allocation base used to allocate the costsb. A grouping of individual costs whose total is

allocated using one allocation basec. The product, service or department that is to

receive the allocationd. None of the above

Answer: cThe product, service or department that is to receive the allocation


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) to other costs in the pool

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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

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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


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?


Selecting an Allocation Base


In the cost allocation process, an allocation base:a. Must be some characteristic that is common

to all of the cost objectivesb. Ideally should result in cost being allocated

based on a cause-and-effect relationshipc. Both a and bd. None of the above

Answer: c Both a and b


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


Direct Method – Mason Furniture

Slide 6-23

Allocate janitorial cost of $100,000 Allocation base: square feet

Assembly department: 20,000 square feetFinishing department: 30,000 square feet

Calculate the allocation rate:$100,000 / (20,000 + 30,000) = $2/sq ft

Allocation to production departments:Assembly dept.:20,000 sq ft x $2 = $40,000Finishing dept.: 30,000 sq ft x $2 = $60,000



Slide 6-24

Allocate personnel cost of $200,000 Allocation base: number of employees

Assembly department: 60 employeesFinishing department: 40 employees

Calculate the allocation rate:$200,000 / (60 + 40) = $2,000/employee

Allocation to Production DepartmentsAssembly dept: 60 x $2,000 = $120,000Finishing dept: 40 x $2,000 = $80,000


Direct Method of Allocating Service Department Costs

Service department costs allocated to production departments but not to other service departments


The direct method of allocating costs:a. Allocates service department costs to other

service departmentsb. Allocates only direct costsc. Allocates service department costs to

production departments onlyd. Both b and c

Answer: cAllocates service department costs to production departments only


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

Calculate the mailroom allocation rate

The mailroom allocation rate =


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 = $320,000Bathtubs 40 employees * $4,000 rate = $160,000Vanities 30 employees * $4,000 rate = $120,000


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


Problems with Cost AllocationPotential problems are brought about by:

1. Allocations of costs that are not controllable2. Arbitrary allocations3. Allocation of fixed costs that make the fixed

costs appear to be variable costs4. Allocations of manufacturing overhead to

products using too few overhead cost pools5. Use of only volume-related allocation bases

Slide 6-31

Learning objective 2: Identify potential problems with cost allocation, discuss activity-based costing (ABC) and cost drivers, and distinguish activity based costing (ABC) from activity-based management (ABM).

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

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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 6-33


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 6-34


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 6-35


Lump Sum Allocations Allocations of fixed costs must be

made in such a way 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 6-36


When fixed costs are stated on a per unit basis:

a. Fixed costs are said to be controllableb. Fixed costs may appear to be variable to

managers receiving allocationsc. A lump-sum allocation has been maded. Divisions with high sales receive a low

amount of allocated costs

Answer: bFixed costs may appear to be variable to managers receiving allocations

Slide 6-37


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 6-38


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 6-39

Too Few Cost Pools


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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 6-41


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 6-42


Which of the following is not a volume-related cost driver?

a. Direct labor hoursb. Direct labor costc. Machine timed. Time to set up a production run

Answer: dA production run will take the same amount of time to set up no matter how many units are in the production run

Slide 6-43


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 6-44


The ABC Approach

Slide 6-45


Relating Cost Pools to Products Using Cost Drivers

The company will estimate the total cost assigned to each cost pool

The company will then decide on an appropriate driver, such as number of inspections for inspection costs

The company will then estimate the activity in the driver

The overhead allocation rate is:

Slide 6-46


Common Activities and Associated Cost Drivers

Slide 6-47


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 6-48

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 6-49




Slide 6-50


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 setupInspections $3,000,000 / 15,000 = $200 per inspection

Slide 6-51


Power Electronics has two products: EP150

10 setups 3 inspections

EP175 40 setups 8 inspections

Calculate the overhead applied to EP150Equipment setups 10 * $150 per setup = $1,500Inspections 3 * $200 per inspection = $600Total overhead $1,500 + $600 = $2,100

Slide 6-52


Power Electronics has two products: EP150

10 setups 3 inspections

EP175 40 setups 8 inspections

Calculate the overhead applied to EP175Equipment setups 40 * $150 per setup = $6,000Inspections 8 * $200 per inspection = $1,600Total overhead $6,000 + $1,600 = $7,600

Slide 6-53


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 6-54


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 6-55


Fixed and Variable Costs

Slide 6-56


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 6-57


Activity-Based Management

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Activity Based Management

Slide 6-59


Appendix The steps in activity-based management are:

1. Determine major activities2. Identify resources used by each activity3. Evaluate the performance of the activities4. Identify ways to improve the efficiency

and/or effectiveness of the activities

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Copyright© 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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prepared by debby bloom-hill cma, cfm. chapter 6 cost allocation & activity-based costing cost...

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