Managerial accounting 5th jiambalvo ch06

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

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Prepared by

Debby Bloom-Hill

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Purposes of Cost Allocation

 To provide information for

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Slide 6-4 Learning objective 1: Explain why indirect

costs are allocated

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 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

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 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

costs are allocated

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 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

costs are allocated

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 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

costs are allocated

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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

Indirect costs are allocated to provide full cost

Test Your Knowledge 1

costs are allocated

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Cost-Plus Contracts

costs are allocated

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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

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Slide 6-12 Learning 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

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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

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 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)

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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 and-effect relationship

cause- 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

 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

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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?

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Selecting an Allocation

Base

Selecting an Allocation

Base

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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

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Allocating Service Department

 Formed by service departments

 Allocated to production departments

Slide 6-22 Learning objective 3: Discuss allocation of

service department costs

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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 + 30,000) = $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 = Learning objective 3: Discuss allocation of

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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 / (60 + 40) = $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

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Direct Method of Allocating

Service Department Costs

Direct Method of Allocating

Service Department Costs

Service department costs allocated to

production departments but not to other

service departments

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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

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Furniture

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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 =



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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 =

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Allocating Budgeted and Actual 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

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Problems with Cost

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

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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 6-32 Learning objective 4: Identify potential

problems with cost allocation

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 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

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Arbitrary Allocations

 Cost allocations are inherently

arbitrary

 Typically there are numerous

allocation bases that are equally

 Managers reject allocations which cast

an unfavorable light on their performance

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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

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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

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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

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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

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 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

Too Few Cost Pools

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Using Only Volume-Related

Allocation Bases

 Some firms allocate manufacturing

overhead based on volume, using

allocation bases like

 Direct labor hours, or

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 The problem with the traditional

approach is that it assumes that all

overhead costs are proportional to

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Which of the following is not a related cost driver?

volume-a Direct labor hours

b Direct labor cost

in the production run

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Activity-Based Costing

(ABC)

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

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The ABC Approach

Slide 6-44 Learning objective 5: Discuss activity-based

costing (ABC) and cost drivers

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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:



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Common Activities and Associated Cost Drivers

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 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

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 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

Activity Based Costing- McMaster Screen Technologies

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Activity Based Costing- McMaster Screen Technologies

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Power Electronics uses two cost pools

Learning objective 5: Discuss

activity-based costing (ABC) and cost drivers

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Power Electronics has two products:

Equipment setups 10 * $150 per setup = $1,500

Inspections 3 * $200 per inspection = $600

Total overhead $1,500 + $600 = $2,100

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Power Electronics has two products:

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

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