Chapter Six

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Chapter Six

• Cost Allocation and
• Activity Based Costing

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Objectives

• Explain why indirect costs are allocated and
  describe the cost allocation process.
• Discuss allocation of service department costs.
• Identify potential problems with cost allocation.
• Describe activity-based costing (ABC) and cost
  drivers.

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Purposes of Cost Allocation
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Rationale 1 To Provide Information for Decision
Making
From a decision making standpoint, the allocated
cost should measure the opportunity costs of
using scarce company resources.
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Rationale 2 To Reduce Frivolous Use of Common
Resources
If costs are not allocated, these resources
appear free to the users. But scarce resources
never come with zero costs.
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Rationale 3 To Encourage Evaluation of Services
The flip-side of the previous point (to reduce
frivolous usage) is to compel the current users
to evaluate the costs and benefits of the
services for which they are being charged
(assuming they have a choice of using more or
less of it).
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Rationale 4 To Provide Full Cost Information

• GAAP requires full-costing for external reporting
  purposes.
• In the long-run, all costs must be covered.
• Therefore even committed fixed costs that are
  beyond the control of a manager may have to be
  allocated to products.

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Full cost allocation example

• How might you allocate Depreciation of the
  building in which products is produced. Suppose
  your company produces 15 different product lines.
  How much depreciation do you assign to each
  product?
• Answer maybe you assign it based on floor space
  used for each product.

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Full Cost allocation and the product life cycle.

• Your company develops a new software product X.
  The actual production cost of the units is very
  low. Most of the cost is the fixed cost of
  developing the product and introducing it to the
  market.
• Product development is carried out by the
  engineering department, and promotion by the
  marketing department. They are involved with many
  products.
• We may need to allocate some of these department
  costs to X in order to find out if it will be
  profitable or what price we need to charge.

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Process of Cost Allocation

• Steps include
• Identify the cost objectives (the targets of
  allocation)
• Form cost pools and select the allocation base
  which relates the cost pools to the cost
  objectives.

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Process of Cost Allocation
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Determining the Cost Objective
Cost Objective Determine the product, service or
department that is to receive the allocation. On
the next slide we see some examples.
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Determining the Cost Objective
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Forming Cost Pools

• Cost pool A grouping of individual costs, the
  sum of which is allocated using a single
  allocation base.
• Cost pools could include
• Total departmental costs (e.g. costs incurred by
  maintenance or personnel departments)
• Costs of Major Activities (equipment setups)

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Selecting an Allocation Base

• Allocation Base Very important to choose a base
  that relates the cost pool to the cost
  objectives.
• Allocation should be based on a cause-and-effect
  relationship between costs and objectives.
• But if cause-and-effect cannot be established,
  other approaches may have to be used.

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Other Approaches to Cost Allocation
(Fixed-Indirect)

• Relative benefits approach.
• Ability to bear costs.
• Equity approach.

These methods should only be applied when you
must allocate costs, but cannot find a cause and
effect relation.
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Allocating Service Department Costs

• Manufacturing firms are often organized into
  production and service departments.
• Service departments provide services to
  production departments as well as to each other,
  but are not part of the production process
  itself.
• EXAMPLES Maintenance Department
• Information Technology Services
• Personnel Department
• Purchasing Department
• Engineering Department

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Allocating Service Department Costs

• A commonly used approach is the direct method of
  allocating service department costs to
  manufacturing overhead of production departments
  (ignoring use by one service department of
  another service departments services).

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Direct Method of Allocating Service Department
Costs
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Direct Method of Allocating Service Department
Costs
Bradley Furniture Example
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Allocating Budgeted vs. Actual Service Department
Costs

• Managers should allocate budgeted rather than
  actual costs.
• In this way inefficiencies cannot be passed on to
  production.
• Variances from budget are the responsibility of
  the service department itself.

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Some problems with cost Allocation in practice

• Allocation of non-controllable costs
• Allocations of fixed costs which make the fixed
  costs appear to be variable.
• Allocations of manufacturing overhead to products
  using too few overhead cost pools.
• Use of only volume-related allocation bases.

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Responsibility Accounting and Controllable Costs

• Responsibility accounting holds someone in some
  unit accountable for generating revenue and
  controlling costs.
• Managers should be held accountable only for
  controllable costs.
• PROBLEMS
• Sometimes it is difficult to determine at what
  level a cost is controllable.
• Full costing requires allocation of some
  committed fixed costs that are not controllable
  in the short run.

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Unitized Fixed Costs and Lump-Sum Allocations

• Unitized fixed costs pose a significant problem.
• Costs that are fixed (in the short run), are
  often divided by some base and allocated as if
  they were variable (per-unit).
• Importantly, this is a question of perspective.
  In the long run all costs are variable and the
  selling price per unit must exceed the full cost
  to make a profit.

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Lump-Sum Allocations

• For short run use the remedy may be to allocate
  these costs as lump-sum allocations (not
  unitized).
• 2. Lump-sum allocations then appear as fixed
  costs which is correct for cost volume profit
  analysis. Using CVP analysis is often superior
  to unitizing fixed costs.

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Do we have enough cost pools?

• Too few cost pools may cause serious product
  costing distortions.
• Generally, the more cost pools, the more accuracy
  is achieved.
• In practice the question is Does the benefit of
  more accurate allocation methods (i.e.more cost
  pools) outweigh the cost of obtaining this
  information?

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Do we have enough cost pools?

• Example of too few cost pools a firm allocates
  all of its overhead costs using direct labor
  hours but it has two production departments
  machining and assembly.
• It would be better to use a separate cost pool
  for each department, and use machine hours for
  the machining department.

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Using Only Volume-Related Allocation Bases

• Some manufacturers allocate manufacturing
  overhead to products using a single volume
  measure (such as)
• labor hours
• machine hours
• Units of product
• HOWEVER
• Not all overhead costs vary in relation to a
  simple measure of volume!

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Set up costs

• For example, a single setup might work for a
  400,000 unit production run just as well as a
  20,000 unit production run.
• If we allocate the cost of the setup based on
  units, too much will be allocated to the 400,000
  unit batch and too little to the 20,000 unit
  batch.

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Activity-Based Costing
Activity-Based Costing (ABC) is a relatively
recent development in management accounting. ABC
develops cost pools for each type of activity and
develops an overhead rate using the cost driver
which is specific for that activity.
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The ABC Approach

• Identify the major activities that cause overhead
  costs to be incurred.
• Group costs of activities into cost pools.
• Identify the measures of activities (the cost
  drivers)
• Relate costs to products using the cost drivers,
  either unitizing them or making a lump sum
  allocation.

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The ABC Approach
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Examples of Activities

• Processing purchase orders.
• Handling materials and parts.
• Inspecting incoming material and parts.
• Setting up equipment.
• Producing goods using manufacturing equipment.
• Supervising assembly workers.
• Inspecting finished goods.
• Packing customer orders.

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Examples of Cost Drivers

• Number of purchase orders processed.
• Number of material requisitions.
• Number of setups.
• Number of machine hours.
• Number of assembly labor hours.
• Number of inspections.
• Number of boxes shipped.
• Number of deliveries.
• Number of flights

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Example Printing Costs

• Much of the costs of printing a book are in
  setting up the document for printing.
• Suppose the set up costs per month are 168,000
  and we do 2 set ups.
• The demand for book A is 2,000 copies requiring 1
  set up
• The demand for book B is 40,000 copies requiring
  1 set up

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Example printing costs

• If we take the set up costs and divide them by
  the number of books we get
• (168,000) / (2,000 40,000)
• 168,000/42,000 4 per book.
• Using ABC instead, we obtain a cost per set up
  of 168,000/2 84,000. Then we divide the
  allocated cost by the size of each book run.

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Printing costs using ABC

• The printing set up cost of Book A
• 84,000/2,000 42
• The printing set up cost of Book B
• 84,000/40,000 2.10
• Allocating based on units alone (4) assigns too
  much cost to each unit of book B and too little
  to Book A. ABC allocation is more accurate.

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Pros and Cons of ABC

• Benefits
• ABC is less likely than traditional costing to
  under cost or over cost products.
• ABC may lead to improvements in cost control.
• Limitations
• ABC is expensive to implement relative to the
  traditional system.

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Quick Review Question 1

• The direct method of allocating costs
• Allocates service department costs to other
  service departments.
• Allocates only direct costs of services.
• Allocates service department costs to production
  departments only.
• Does not allocate service department costs.

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Quick Review Question 1

• The direct method of allocating costs
• Allocates only direct costs of services.
• Allocates service department costs to other
  service departments.
• Allocates service department costs to production
  departments only.
• Does not allocate service department costs.

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Quick Review Question 2

• In the cost allocation process, the cost
  objective is
• The allocation base used to allocate the costs.
• A grouping of individual costs whose total is
  allocated using one allocation base.
• The product, service or department that is to
  receive the allocation
• The rationale for allocating costs.

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Quick Review Question 2

• In the cost allocation process, the cost
  objective is
• The allocation base used to allocate the costs.
• A grouping of individual costs whose total is
  allocated using one allocation base.
• The product, service or department that is to
  receive the allocation
• The rationale for allocating costs.

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Quick Review Question 3

• Traditional (non ABC) overhead allocation may
  cause
• High volume products to be over costed
• High volume products to be under costed
• Low volume products to be over costed
• None of the above

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Quick Review Question 3

• Traditional (non ABC) overhead allocation may
  cause
• High volume products to be over costed
• High volume products to be under costed
• Low volume products to be over costed
• None of the above

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Quick Review Question 4

• Estimated Data
• Machine setup costs 100,000 Number of setups
  400
• Inspections costs 24,000 No. of inspections 600
• Actual Data
• Job 1234 required 2 setups and 10 inspections
• Using ABC the amount of setup and inspection
  cost allocated to job 1234 should be
• a. 600
• b. 900
• c. 1,000
• d 1,200

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Quick Review Question 4

• Estimated Data
• Machine setup costs 100,000 Number of setups
  400
• Inspections costs 24,000 No. of inspections 600
• Actual Data
• Job 1234 required 2 setups and 10 inspections
• Using ABC the amount of setup and inspection
  cost allocated to job 1234 should be
• a. 600
• b. 900
• c. 1,000
• d 1,200