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Chapter 6 Cost Allocation and Activity-Based Costing by gvl14091

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									Chapter Six

        Cost Allocation and
       Activity Based Costing
Objectives
1. Explain why indirect costs are allocated
   and describe the cost allocation process.
2. Discuss allocation of service department
   costs.
3. Identify potential problems with cost
   allocation.
4. Describe activity-based costing (ABC) and
   cost drivers.
Purposes of Cost Allocation
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.
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.
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).
Rationale #4: To Provide Full
Cost Information
1. GAAP requires full-costing for external
   reporting purposes.
2. 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.
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.
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.
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.
Process of Cost Allocation
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.
Determining the Cost Objective
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:
1. Total departmental costs (e.g. costs
   incurred by maintenance or personnel
   departments)
2. Costs of Major Activities (equipment
   setups)
Selecting an Allocation Base
1. Allocation Base: Very important to
   choose a base that relates the cost
   pool to the cost objectives.
2. Allocation should be based on a
   cause-and-effect relationship between
   costs and objectives.
3. But if cause-and-effect cannot be
   established, other approaches may
   have to be used.
Other Approaches to Cost
Allocation (Fixed-Indirect)
1. Relative benefits approach.
2. Ability to bear costs.
3. Equity approach.
These methods should only be applied
when you must allocate costs, but cannot
find a cause and effect relation.
     Allocating Service Department Costs

1. Manufacturing firms are often organized into
   production and service departments.
2. 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
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
   department’s services).
Direct Method of Allocating
Service Department Costs
Direct Method of Allocating
Service Department Costs
Bradley Furniture Example:
Allocating Budgeted vs. Actual
Service Department Costs
1. Managers should allocate budgeted
   rather than actual costs.
2. In this way inefficiencies cannot be
   passed on to production.
3. Variances from budget are the
   responsibility of the service department
   itself.
Some problems with cost
Allocation in practice
1. Allocation of non-controllable costs
2. Allocations of fixed costs which make
   the fixed costs appear to be variable.
3. Allocations of manufacturing overhead
   to products using too few overhead
   cost pools.
4. Use of only volume-related allocation
   bases.
 Responsibility Accounting and
 Controllable Costs
1. Responsibility accounting holds someone in
   some unit accountable for generating
   revenue and controlling costs.
2. Managers should be held accountable only
   for controllable costs.
                   PROBLEMS
1. Sometimes it is difficult to determine at what
   level a cost is controllable.
2. Full costing requires allocation of some
   committed fixed costs that are not
   controllable in the short run.
Unitized Fixed Costs and
Lump-Sum Allocations
1. Unitized fixed costs pose a significant
   problem.
2. Costs that are fixed (in the short run), are
   often divided by some base and allocated
   as if they were variable (per-unit).
3. 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.
Lump-Sum Allocations
1. 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.
Do we have enough cost pools?
1. Too few cost pools may cause serious
   product costing distortions.
2. Generally, the more cost pools, the more
   accuracy is achieved.
3. 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?
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.
Using Only Volume-Related
Allocation Bases
1. Some manufacturers allocate
   manufacturing overhead to products using
   a single volume measure (such as):
   a. labor hours
   b. machine hours
   c. Units of product
   HOWEVER:
   Not all overhead costs vary in relation to a
   simple measure of volume!
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.
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.
The ABC Approach
1. Identify the major activities that cause
   overhead costs to be incurred.
2. Group costs of activities into cost
   pools.
3. Identify the measures of activities (the
   cost drivers)
4. Relate costs to products using the cost
   drivers, either unitizing them or
   making a lump sum allocation.
The ABC Approach
Examples of Activities
1. Processing purchase orders.
2. Handling materials and parts.
3. Inspecting incoming material and parts.
4. Setting up equipment.
5. Producing goods using manufacturing
   equipment.
6. Supervising assembly workers.
7. Inspecting finished goods.
8. Packing customer orders.
Examples of Cost Drivers
1.   Number of purchase orders processed.
2.   Number of material requisitions.
3.   Number of setups.
4.   Number of machine hours.
5.   Number of assembly labor hours.
6.   Number of inspections.
7.   Number of boxes shipped.
8.   Number of deliveries.
9.   Number of flights
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
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.
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.
Pros and Cons of ABC
Benefits:
1. ABC is less likely than traditional costing to
   under cost or over cost products.
2. ABC may lead to improvements in cost
   control.

Limitations:
1. ABC is expensive to implement relative to
   the traditional system.
Quick Review Question #1
1. The direct method of allocating costs:
   a. Allocates service department costs
      to other service departments.
   b. Allocates only direct costs of
      services.
   c. Allocates service department costs
      to production departments only.
   d. Does not allocate service
      department costs.
Quick Review Question #1
1. The direct method of allocating costs:
   a. Allocates only direct costs of
      services.
   b. Allocates service department costs
      to other service departments.
   c. Allocates service department costs
      to production departments only.
   d. Does not allocate service
      department costs.
Quick Review Question #2
1. In the cost allocation process, the cost
   objective is:
    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. The rationale for allocating costs.
Quick Review Question #2
1. In the cost allocation process, the cost
   objective is:
    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. The rationale for allocating costs.
Quick Review Question #3
    Traditional (non ABC) overhead allocation
     may cause:
    a. High volume products to be over costed
    b. High volume products to be under costed
    c. Low volume products to be over costed
    d. None of the above
Quick Review Question #3
   Traditional (non ABC) overhead allocation
    may cause:
     a.High volume products to be over costed
     b.High volume products to be under costed
     c.Low volume products to be over costed
     d.None of the above
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
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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