Advanced Cost Accounting

Lectures 2017

Janne Järvinen
Professor, Management Accounting and Control Systems

P.O. BOX 4600, 90014 University of Oulu, FINLAND • tel. +358 294 480 000, fax +358 8 553 2906 • www.oulubusinessschool.fi
Course Material
Coursebook:
1. Zimmerman: Accounting for Decision-Making and
Control, chapters 7-11.

Articles (Available from library –ejournals)

1. Armstrong P. (2002). The costs of activity-based management.

Accounting, Organizations and Society 27, 99–120.
2. Balakrishnan, R., Labro, E. & Sivaramakrishnan, K. (2012a). Product
costs as decision aids: An analysis of alternative approaches (part 1).
Accounting Horizons 26(1), 1-20.
3. Balakrishnan, R., Labro, E. & Sivaramakrishnan, K. (2012b). Product
costs as decision aids: An analysis of alternative approaches (part 2).
Accounting Horizons 26(1), 21-41.
4. Dopuch N. (1993). A perspective on cost drivers. The Accounting
Review 68(3), 615–620.

2
Course materials
Other
1. Kaplan & Anderson (2004) : Time-driven activity-based costing.
Harvard Business Review
2. Järvinen & Väätäjä (2017) Costing system sophistication and
information systems in SMEs: three interventionist case
studies.
3. Cokins & Paul (2012) Time-driven or driver rate -based ABC?
Strategic Finance, February.
http://sfmagazine.com/post-entry/february-2016-time-driven-
or-driver-rate-based-abc/
4. Cooper & Kaplan, The Design of Cost Management Systems, 2nd
ed., pages 208-217 (Activity-Based Costing: Introduction) and
243-250 (Measuring the Use of Resource Capacity)

P.O. BOX 4600, 90014 University of Oulu • tel. (08) 553 2905, fax (08) 553 2906 • www.oulubusinessschool.fi
Zimmerman: Accounting for Decision-
Making and Control
Chapters 7 and 8 describe some general features of cost
allocation and the trade-offs that arise in using cost
allocation for decision making and decision control.

Chapter 9 describes how manufacturing firms use absorption

costing to apply costs to products manufactured.

Chapters 10 and 11 describe criticisms of absorption cost

systems. Chapter 10 shows how variable costing can
mitigate absorption costing’s incentives to overproduce.

Chapter 11 shows how activity-based costing can mitigate

absorption costing’s tendency to give inaccurate product
costs. Chapter 11 also compares activity-based costing
(ABC) to traditional absorption costing.

4
Assignments

Assignment / task Return date max points

Carlos Sanguine Winery (Zimmerman, Chapter 8) March 27th 10
Absorption vs. full costing April 2nd 10
Pilot Plant (Zimmerman, Chapter 11) April 6th 10
Electronic Parts April 9th 10
TDABC learning diary (assumes attendance) April 22nd 16
Term Paper May 8th 32
Spreadsheet excercise May 13th 80
Lecture attendance 12
Maximum no of points from the course 180

P.O. BOX 4600, 90014 University of Oulu • tel. (08) 553 2905, fax (08) 553 2906 • www.oulubusinessschool.fi
 EVALUATION

Points Grade

162 5

144 4

126 3

108 2

90 1

P.O. BOX 4600, 90014 University of Oulu • tel. (08) 553 2905, fax (08) 553 2906 • www.oulubusinessschool.fi
Approximate contents

Lecture no / Approximate contents

1 Cost allocation theory

2 Cost allocation practise. Absorption cost systems. Process and job-order

costing.

3 Criticisms of absorption cost systems. Link between financial accounting and

cost accounting. Direct / marginal costing.

4 Potential inaccuracy of volume-based allocations, activity-based costing.

5
Characteristics of activity-based costing. ABC extensions

6 Time-Driven ABC
Future of Management Accounting Systems

7
 Lecture 1
Cost allocation
Theoretical considerations

•Pervasiveness of Cost Allocations

•Reasons To Allocate Costs
•Incentive/Organizational Reasons for Cost Allocations
•Cost Allocations as Taxes

8
Definitions and Glossary
Cost object is a product, process, department, or program that
managers wish to cost.

Common cost is a cost shared by two or more cost objects.

Examples: Accounting, building maintenance, supervisors.

Cost allocation is the assignment of indirect, common, or joint costs to

cost objects.

Allocation base is the measure of activity used to allocate costs.

Examples: hours, floor space, sales dollars.

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Steps of Cost Allocation
1. Defining the cost objects. Decide what departments,
products, or processes to cost.

2. Accumulating the common costs to be assigned to the cost

objects. (Also known as indirect cost pools.)

3. Allocating the accumulated costs to cost objects using an

allocation base. (Also known as cost assignment,
apportionment, or distribution.) Usually the allocation base
approximates how the cost objects consume common
resources.

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Surveys of Cost Allocation
Practices by Large Corporations
What corporate-level costs are allocated to profit centers?
Most often: selling and distribution expenses
Least often: income taxes

What allocation bases are used?

Meter: measure actual use
Negotiate: estimate usage
Prorate: based on relative proportions of sales, profits, or assets

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External Cost-based Contracts
Usage: Some institutions without strong profit motives purchased
goods and services with cost-based contracts. Suppliers were paid
for their reported costs plus a stated profit percentage.

Examples: Government military purchases, municipality purchases of

health care services
Incentives: Contractors maximize the indirect costs allocated to cost-
based contracts.

Responses of these:
1. Tighter regulation of cost allocation practices.
2. Abandon cost-based contracts in favor of fixed-price contracts.

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External Reasons for Cost
Allocation
External financial reports:
• Allocate production costs between expenses (expired costs,
such as cost of goods sold) and assets (unexpired costs,
such as ending inventory.

Income taxes:
• Related to external reporting

Third-party reimbursement:
• Some government contracts (e.g. health care) and regulated
industries (e.g. energy grids, telecom networks etc) use cost-
plus contracts

Bookkeeping costs are reduced if the same costs are used for
external and internal reporting.13
Internal Reasons for Cost
Allocation
Decision Making
• Managers will try to reduce their use of common resources
that have relatively high cost allocation rates

Decision Control
• Central executives can control behavior of operating
managers with cost allocation policy. Cost allocation affect
behavior (how much indirect costs are allocated to
departments).

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Cost Allocations are an internal
Tax System
Cost allocations are economically equivalent to taxes on resource
factors.
Increasing cost allocation rates (or taxes) decrease profits reported
by the cost center bearing the allocated costs.
Increasing the cost allocation rate (or taxes) motivates profit-
maximizing managers to use less of the resources with higher
cost allocation rates.

Zimmerman’s example shows imposing an overhead rate R on

salespersons decreases the optimum level of salespersons.
This is economically equivalent to a payroll tax on salesperson
compensation.

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Microeconomic Analysis of Cost
Allocation
Manager’s decision problem:
Minimize cost to produce sales level Q by choosing levels for
two inputs: advertising (A) and salespersons (S) .

With no cost allocation : Costs = PAA + PsS

With cost allocation, overhead rate R is added to salesperson

costs:
Costs = PAA + (Ps+R)S

Since R makes sales persons more expensive, the optimum level

of salespersons decreases
Some advertising is substituted for salespersons, and the optimum
level of advertising increases
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Allocation Proxies for Externalities
Positive externalities are benefits imposed on other individuals
without their participation in the decision and without
compensation for the benefits imposed on them.

Negative externalities are costs imposed on other individuals

without their participation in the decision and without
compensation for the costs imposed on them.

When costs are allocated, the overhead rate is a proxy for

externalities that are hard to measure.

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Choice of Allocation Base
The measurable activity in the allocation base should be closely related to
the hard-to-measure opportunity cost.

Good base: Allocating utility costs with meters for each department.
Worse base: Allocating utility costs based on floor space.

Examples of allocation bases:

Overhead Cost Allocation Bases

Executive salaries Time spent or personnel costs
Central office rent Square meter or personnel
costs
Advertising and marketing Time spent or number of
customers
Data processing and accounting Time spent or number of
transactions
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Insulating vs. Noninsulating
Allocations
Insulating allocation scheme: The allocation base is chosen so that the
costs allocated to one division do not depend on the operating
performance of some other division.

Example: Floor area or a fixed pre-determined rate.

Noninsulating allocation scheme: The allocation base is chosen so that

the costs allocated to one division does depend on the operating
performance of some other division.

Example: Share of sales or costs of each division.

Both schemes motivate mangers to reduce waste of common resources,

but they differ in other incentives.

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Insulating vs. Noninsulating :
Incentives
Insulating cost allocation:
Performance of a division does not influence rewards for others.
Each division bears its own risk of events outside its control.

Noninsulating allocation:
Creates incentives for mutual monitoring and cooperation because
rewards depend on each other
Reduce risk to managers of events outside their control. If random events
are uncorrelated across divisions, then when one division is doing
poorly, the others are probably doing well and bear more of the costs.

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21
Exercise 1
A sports equipment manufacturer makes to types of balls.
There is no beginning inventory and during the year the
manufacturer makes 20.000 soccer balls and 40.000
footballs. Indirect manufacturing costs during the year are
$100.000. During the year, all soccer balls are sold and
30.000 of the footballs are sold.
The company is considering two possible methods of
allocating indirect manufacturing costs.
• The first method allocates $80.000 to soccer balls and
$20.000 to the footballs.
• The second method allocates $40.000 to the soccer balls
and $60.000 to the footballs.
Which method causes a higher reported profit this period?

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Exercise 2
A web-page design firm has two types of clients: those
that request a cost-plus 20 % contract and those that
request a fixed fee of $20.000 for design services. The
firm completes 50 designs of each type during the year.
• The average direct costs of each design are $10.000.
• Indirect costs for the design firm are $500.000.
The method of allocating indirect costs assigns $200.000
to the cost-plus design and $300.000 to the fixed-fee
designs. Please calculate the profit for the firm?

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 Lecture 2
Cost allocation: practical considerations

24
Methods of Service Department
Allocation
Methods for complex firms with at least 2 service departments and at least
2 operating departments
Alternative methods:
• Direct allocation (suora kohdistus / vyörytys / allokaatio)
• Step-down allocation (vasemmalta-oikealle –vyörytys)
• Reciprocal allocation (ristiinvyörytys)

Direct method and step-down allocation method are included in the

requirements of the basic Cost Management Systems -course (which
is prerequisite to this course) as well as basic Johdon laskentatoimi –
course. You are expected to be familiar with the methods.
Reciprocal allocation method will be included in the Microsoft Excel –
exercises). Please study it from Zimmerman’s book (Chapter 8)

25
Service Allocation: 1. Direct
Method
Procedure:
Ignore each service department’s use of other service departments.
Allocate service department costs only to operating departments.

Advantages:
Simple to administer and explain.

Disadvantages:
Allocations are not accurate estimates of opportunity costs when service
departments use other service departments.
Incentives exist for service departments to make excessive use of other
service departments.

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Service Allocation: 2. Step-down
Method
Procedure:
Start with one service department and allocate all of its costs to the
remaining service and operating departments.
Continue one-by-one through each service department allocating all
direct costs of that department and costs allocated to it.
A good way of choosing the order of allocation is by (1) most reliable
“cause and effect” cost driver, (2) number of other departments
serviced, and (3) finally, as the default, total budget of department.

Advantages:
Considers some of the interdependence of service departments

Disadvantages:
Resulting allocations are inaccurate estimates of opportunity costs.
Allocation less than opportunity cost for first department
Allocation more than opportunity cost for last department
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Service Allocation: 3. Reciprocal
Method
Procedure:
Write equations defining variable cost relationships among divisions.
Solve system of simultaneous equations with linear algebra.
Allocate fixed costs based on each operating division’s planned use of
the service department’s capacity.

Advantages:
Most accurate method

Disadvantages:
Slightly harder to set up and compute solution
Difficult to explain results to unsophisticated managers

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Service department allocation vs. fixed-
fee charges
Difference between
(i) allocating costs, and
(ii) charging a predetermined, lump-sum service fee
• internal invoicing
• service departments receive internal revenues, and are
able to calculate a P&L-report
• insulating allocation

Pros and cons of charging fixed service fees

29
Reasons to Allocate Service
Department Costs
Encourages reduction of use of costly services
• With no cost allocation (zero transfer prices), management must
use non-price priority schemes to control use.

Reveals economic demand for services

• Rational users will pay a transfer price only when the benefits are
greater than or equal to that price.

Compare internal service departments to external vendors

• Gross inefficiency is revealed when internal transfer prices greatly
exceed external prices.

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Joint Costs Defined
(jakamattomat yhteiskustannukset,
yhtenäiskustannukset)
Joint cost is incurred to produce two or more outputs
from the same input.
Joint costs occur only in disassembly processes, such
as refining and food processing.
Common costs occur in either disassembly or assembly
processes, such as building cars.

31
Joint Costs: Net Realizable Value
Net realizable value (NRV) is the difference between selling price
and costs that would be incurred after the split-off point.

1. Compute NRV of each product after the split-off point. Decide to

produce products with positive NRV, but not with negative NRV.
2. For control and divisional reporting, allocate joint costs to
products in the ratio of the NRV of each product.

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 Joint costs: sell or process further
Wings
Joint
Chicken Costs
Pieces Breasts
Separable
Split Off Point Process Costs
What is Relevant?
•Joint costs?
•Separable Processing costs

If incremental revenue > separable costs, then process

further 33
Death Spiral
Death spiral occurs when large fixed costs of a
common resource are allocated to users who
could decline to use that resource. As the
allocated costs increase, some users choose
to decrease use. Then the fixed costs are
allocated to the remaining users, more of
whom use less. This process repeats until no
users are willing to pay the fixed costs.

Possible solutions to death spiral:

When excess capacity exists, charge users
only for variable costs.
Reduce the total amount of fixed costs
allocated.
34
Death Spiral Example: Internal
Services
Internal customer service desk:
Service desk allocates fixed costs to users.
If some users are allowed to switch to outside support
services, the fixed costs allocated to remaining users
increase.
Eventually, the number of users of the service desk is
so small that the department is closed and the
services are outsourced.

35
Allocating Capacity Costs:
Depreciation
Depreciation is fixed cost. One way to solve the
death spriral is not to allocate some (or all) of the
FC. For example, only allocate the FC of the
capasity actually being used. If there is 40% of
excess capasity, only allocate 60% of the
depreciation.

36
Allocating Capacity Costs:
Depreciation
Accounting depreciation represents the annual historical cost of
acquired capacity.

Allocating depreciation involves a tradeoff

• with excess capacity, allocation causes underutilization.
• However, allocation controls overinvestment.

Most firms allocate depreciation to users.

If confronted with a choice between control and decision making -

accounting systems seem often to choose control.

37
Absorption cost systems
(täyskatteellinen laskenta)

38
Manufacturing versus
Nonmanufacturing Settings
Manufacturing settings
Product costs: costs of manufacturing goods
Period costs: nonmanufacturing costs
Costs must be allocated between cost of goods sold (expense or
expired costs) and ending inventories (assets or unexpired
costs)

Nonmanufacturing settings (merchandising and service firms)

Product costs: costs of inventory held for resale
Period costs: all other costs
Most product costs for physical goods are directly traced to external
contacts and do not require cost allocation

39
Two Types of (traditional) Absorption
Systems
Absorption cost systems ensure that all manufacturing costs are assigned
to products either by direct tracing or by cost allocation.

Job order costing (lisäyslaskenta) is used in departments that produce

output in distinct jobs (job order production) or batches (batch
manufacturing).

Process costing (jakolaskenta) is used in departments that produce output

that is not in distinct batches or produce continuous flows, such as
beverages and oil refineries.

In practice, many plants use hybrids of job order and process costing.

40
Job Order Costing
Cost object: Distinct job or batch records are maintained for each
job
Direct traceable costs: Raw materials and direct labor costs are
directly assigned to each job.
Cost allocation: Manufacturing overhead costs (fixed and variable)
that cannot be directly traced are allocated to jobs
Allocation base: An input measure such as machine hours or labor
hours
Overhead rate: Overhead rate is set at beginning of year based on
estimated total overhead costs and estimated volume.

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Cost Flow Sequence

1. Costs are accumulated in three major categories: materials, labor, and

overhead.
2. Direct materials, direct labor, and overhead are assigned to the work-in-process
(WIP) inventory account for each job.
3. When manufacturing is completed, the cost of units completed is transferred
from WIP to the finished goods inventory.
4. When goods are sold, the costs are transferred from the finished goods
inventory account to the cost of goods sold expense account.
5. If any amount remains in the overhead account at the end of the period, it must
be allocated to some inventory or expense account.

Review the Self Study Problems in Zimmerman (Absorption Cost Systems)

42
Inventory Cost Flow Accounting
Assumptions

Inventory cost flow assumptions change the amounts transferred

out of an inventory account when input prices change over
time.

External importance: financial statements, taxes, cost-based

contracts.
Internal importance: decision making and decision control.

1. First In, First Out (FIFO): Oldest items are transferred out first.
When prices are rising, FIFO reports higher net income than
LIFO.
2. Last In, Last Out (LIFO): Newest items are transferred out first.
When prices are rising, LIFO reports lower net income than
FIFO.
3. Specific Identification: Each inventory item is individually
priced.
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Overhead Rate
”yleiskustannus (yk) -lisä”

Prospective overhead rates are set at the beginning of the year

(also known as predetermined overhead rates).

Numerator: Estimated annual budgeted overhead dollars

Denominator: Estimated annual factory volume (input
measure)

Possible input measures: machine hours, direct labor hours

(DLH), direct material dollars, or direct labor dollars

Incentive effect: Managers reduce whichever input used to

allocate overhead.
44
Over/Underabsorbed Overhead
Actual overhead incurred for a year is the amount of
indirect manufacturing costs incurred during the year.

Absorbed overhead (also known as applied overhead) is

the amount of overhead applied to work-in-process
during they year using the predetermined overhead
rate and the actual amount of inputs used.

Underabsorbed overhead exists when actual > absorbed

overhead.

Overabsorbed overhead exists when actual < absorbed

overhead.
45
Disposing of Over/Underabsorbed
Overhead
Overhead accounts must be cleared of over/underabsorbed
overhead at the end of the year.

1. Write off all to cost of goods sold expense account.

• Simplest bookkeeping procedure

2. Allocate among WIP and finished goods inventory, and cost of

goods sold expense account.
• Better if ending inventory levels are significant

3. Recalculate job costs with actual overhead rates.

• Most complex data processing

46
Flexible Budgets to Estimate
Overhead
Recall that

Static budget estimates do not change with volume.

Flexible budget estimates do change with volume.
Forecast annual budgeted overhead dollars with a flexible budget:

Budget = Fixed + Variable

= FOH + (VOH  BV)

where, FOH = Fixed overhead estimate

VOH = Variable overhead rate estimate
BV = Budgeted volume estimate

47
Budgeted Volume: Expected versus
Normal
Expected volume: Volume expected for the coming year.
Decision control: enhanced because transfer prices are adjusted for
changing volume
Decision management: impaired because lower volume raises overhead
rate, and encourages profit centers to raise prices

Normal volume: Long-run average volume over economic cycle.

Decision control: impaired because managers are not held responsible
for short-run volume fluctuations
Decision management: better long-run opportunity cost estimates result
in better pricing decisions

48
Permanent versus Temporary Volume
Changes
How should overhead rate estimates respond to volume changes?

Permanent volume changes:

Write off assets or change estimated useful lives of assets.
Managers may be reluctant to admit that their prior projections need to be
adjusted.

Temporary volume changes:

Assumed to average out over economic cycles
No accounting changes should be made.

49
Plantwide versus Multiple Overhead
Rates
Choices of overhead cost allocation disaggregation:

1. Single overhead cost pool for entire plant (summalisäyslaskenta)

• Easiest to apply, but accounting costs may be very
inaccurate representations of opportunity costs.
2. Many overhead cost pools and overhead rates (lajilisäyslaskenta)
• More data processing, but more accurate costing
3. Two-stage allocation of departmental overhead rates
(kustannuspaikkalisäyslaskenta)
• Allocate to departments, and then to products.

50
Standard costing

Do not confuse predetermined overhead rates with

a standard costing system
Standard cost
• Predetermined norms (or standards) for
materials, labor, and overhead
• Compare actual costs to standard costs -
difference is a variance
ERP-environment: cybernetic standard costing

51
Backflush costing
• Backflush costing is an approach to costing which
delays recording changes in the status of the product
until the finished goods appear
• Backflush costing uses standard costs to work
backward and flush out costs for the units produced
Finished Cost of
Goods Control Goods Sold
Direct Direct
Materials Sale
Allocated
Conversion
Cost Control
Unallocated Conversion Costs

Pages 755 - 763

52
Backflush costing
• Sequential (or synchronous) tracking is a product costing
method in which the accounting system entries occur in the
same order as actual purchases and production
• Manual system vs. an automated system / ERP system
• Trigger point is a stage in the production cycle at which an
accounting entry is made

Traditional Trigger Points:

Purchase Production Completion Sale of a
of Direct of work in of a good finished
Materials process finished unit unit

Pages 755 - 763

53
Process Costing Overview

Production process is a continuous flow without discrete

batches or jobs.
Each process is treated as a separate cost center.
Costs are averaged over large number of production
units that are assumed to be essentially identical.
Decision making usefulness is reduced because costs
for individual batches are not available.

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