COST ACCOUNTING

Accounting for Factory Overhead

Service Costs Allocation

Service or support department is a unit in an organization that contributes in a very indirect way to the conversion of raw materials
in a finished product. These units are the purchasing, personnel, warehousing and maintenance department. Since these departments support
the production department, the costs incurred must be allocated to production departments to determine the full costs of a product.

NOTES:
1. Using the step-down method, if the problem is silent, allocate first the department that serves the most number of departments, if
applicable.
2. If No.1 is not applicable, allocate first the service department that has the highest cost.

Illustration:

The RESA Cinema has two service departments (Uberita and Dayag) and two producing departments (P1 and P2).

Service Departments Operating Departments

Uberita Dayag P1 P2
Direct costs P150 P300
Services performed by Uberita Dept. 40% 40% 20%
Services performed by Dayag Dept. 20% 70% 10%

Required: Compute the allocated cost to departments P1 and P2 using the following method:
1. Direct method
2. Step-down method (cost of department Uberita is allocated first)
3. Step-down method (cost of department Dayag is allocated first)
4. Reciprocal method

Activity-Based Costing (ABC) – is a systematic costing method that uses activities to allocate factory overhead costs and other indirect
costs to products. ABC can provide more accurate data on product cost by using multiple cost drivers that reflect more accurately the causes
of incurred costs.

ABC vs. TRADITIONAL COSTING

Under the traditional costing, factory overhead costs are allocated to products by using a single activity or cost driver (e.g., labor
hours). In some accounting literature, traditional costing is also called peanut-butter costing.
Under ABC, factory overhead costs are allocated to products using several activities or cost drivers that are closely related with the
incurrence of specific factory overhead costs.

STEPS IN IMPLEMENTING ABC:

1. Perform PROCESS VALUE analysis – identifying value-added vs. non value-added activities.
A value-added activity is a non-eliminable activity that incurs costs but increases the worth of the product to the
customer. (e.g., engineering designs modification)
A non value-added activity increases the cost of a product but does not increase its value to customers. (e.g., materials
handling and rework)
2. Identify cost drivers (activities), cost pools and activity centers.
 A cost driver is the particular activity that causes the incurrence of certain costs.
 A cost pool is a group of similar costs usually increased or decreased by a single cost driver.
 An activity center is a unit of organization that performs a set of tasks. It is a part of the production process for which
management wants a separate reporting of the cost of the activity involved. Level of activity centers can be classified into
four general categories:
i. Unit-level activities performed each time a unit is produced
ii. Batch-level activities performed each time a batch of goods is handled or processed
iii. Product-level activities performed to support production (sales) of specific product type
iv. Facility-level activities performed to sustain a facility’s manufacturing process
3. Calculate predetermined overhead rates for each identified activity.
Predetermined overhead rate = Estimated overhead costs ÷ Estimated activity level
NOTE: Estimated figures are used because actual figures are not yet known at the start of the period.
4. Allocate overhead costs to the products on the basis of predetermined overhead rates.

In summary, ABC is a ‘two-stage’ allocation process. First, overhead costs are traced to activities; then, overhead costs are
allocated to products on the basis of the activities performed by a particular product.
ACTIVITY-BASED MANAGEMENT (ABM) integrates ABC with other concepts such as Total Quality Management (TQM) and target
costing to produce a management system that strives for excellence through cost reduction (e.g., eliminating non value-added activities) and
continuous process improvement.

EXERCISES

I. Value-Added and Non-Value-Added Activities

Consider the nine activities that follow.

1. Microsoft: Developing computer coding for a new spreadsheet package

2. General Mills: Painting the office of a maintenance supervisor at a plant that produces cereal
3. Mayo Clinic: Examining a new patient
4. American Airlines: The 90 minutes that a Boeing 757 sits idle on the ground between flights
5. Office Depot: Moving cases of paper from one location to another in the same warehouse
6. Rolex: Attaching a watch band to the watch’s face
7. United States Postal Service: Reprocessing mail that had been sorted incorrectly on a malfunctioning sorting machine.
8. Fidelity Investments: Correcting errors made by company personnel in customer accounts
9. Marriott: Upgrading the quality of bedding used at hotels in very competitive marketplaces
10. Attaching the engine to the mower's body.
11. Installing a new air-conditioning system in the executive offices.
12. Replacing a defective wheel with a new wheel.
13. Designing and printing an owner's instruction manual for a new model.
14. Moving completed mowers to the finished-goods warehouse.
15. Attaching the handle to the mower's body. The process took longer than normal because of a worker slowdown caused by
disgruntled employees.

Required: Categorize each of the activities as either value-added or non-value-added for the companies noted.

II. Activity Levels

Determine the appropriate level for each of the following activities. Indicate whether the activity is unit-level (UL), batch-level (BL),
product-level (PL), facility-level (FL):
1. Equipment set-ups 9. Machine hours
2. Plant supervision and landscaping 10. Indirect materials
3. Prime cost 11. Safety costs at winery
4. Packaging and shipment 12. Truckload shipping costs
5. Advertising 13. Building maintenance costs
6. Heating, lighting and security 14. Bottle and cork cost
7. Designing and changing 15. Development cost of new, after-dinner wine
8. Product order processing 16. Tasting and testing costs

III. Activity-Based Costing

Adventure Company has identified activity centers to which overhead costs are assigned. The cost pool amounts for these centers and their
selected activity drivers for 2015 are as follows:

Activity Centers Costs Activity Drivers

Utilities P 300,000 60,000 machine hours
Scheduling and setup 273,000 780 setups
Material handling 640,000 1,600,000 pounds of materials
The company’s products and other operating statistics follow:

PRODUCTS
Finn Jake Ice King
Direct costs P 80,000 P 80,000 P 90,000
Machine hours 30,000 10,000 20,000
Number of setups 130 380 270
Pounds of materials 500,000 300,000 800,000
Number of units produced 40,000 20,000 60,000
Direct labor hours 32,000 18,000 50,000

Required:
1. Determine the pool rates
2. Allocate the overhead using the pool rates determined above
 3. Determine the total cost of the job

IV: Traditional Costing vs. Activity-Based Costing

Company incurs P800,000 in manufacturing overhead costs. The company has been allocating
Hercules
overhead to individual product lines based on direct labor hours.
Cost Driver Amount in Cost Pool Amount of Activity
Direct labor hours P 300,000 40,000
Number of batches 300,000 1,000
Number of shipments 200,000 500
Total overhead costs P 800,000

Two products have the following characteristics:

Product X Product Y
Direct labor hours 2,000 1,000
Number of batches 20 100
Number of shipments 2 150

Required: Determine the overhead costs to be allocated to each product using:

1. Traditional costing (based on direct labor hours)
2. Activity-based costing

V. Activity-Based Costing

Hawk Construction manufactures and installs standard and custom-made cabinetry for residential homes.
Last year, the company incurred P200,000 in overhead costs. After implementing activity-based costing
(ABC), the company’s accountant identified the following information:
Activity Allocation Base Proportion of Overhead Cost
Materials delivery & handling Number of deliveries 30%
Inspections Number of inspections 25%
Supervision Hours of supervisor time 20%
Purchasing Number of purchase orders 25%

The number of activities for standard and custom-made cabinets is as follows:

Standard Custom-made
Number of deliveries 200 100
Number of inspections 600 400
Hours of supervisor time 1,800 2,200
Number of purchase orders 1,000 1,000

During the past year, Hawk accepted a customer order for a set of custom-made cabinets that would require the following:
Direct labor cost (25 hours at P15 per hour) P 375
Direct materials (wood) (900 ft at P3 per foot) P 2,700
Number of deliveries 3
Number of inspections 5
Hours of supervisor time 5
Number of purchase orders 3

Questions:
1. How much overhead should be applied to the above customer order?
2. What is the total product (manufacturing) cost for the above customer order?

SOLUTION:

Application rates:
Materials & delivery handling: P60,000 ÷ 300 deliveries = P200/delivery
Inspections: P50,000 ÷ 1,000 inspections = P50/inspection
Supervision: P40,000 ÷ 4,000 supervision hours = P10/hour
Purchasing: P50,000 ÷ 2,000 purchase orders = P25/order

Total overhead cost applied to the customer order:

Materials & delivery handling: P200 x 3 deliveries = P 600
Inspections: P50 x 5 inspections = 250
Supervision: P10 x 5 hours = 50
Purchasing: P25 x 3 orders = 75
 Total P 975

Total product cost of customer order:

Direct materials P 375
Direct labor 2,700
Factory overhead 975
Total P 4,050

IV. True or False; Multiple-Choice

1. The direct method of allocating service department costs ignores all of the interactions between service departments.

2. Which of the following methods of allocating the costs of service departments provides the broadest recognition of department
served?
a. Reciprocal allocation b. Step-down allocation c. Direct allocation d. Arbitrary allocation

3. The step-down method of allocating service department costs:

a. is a less accurate method than the direct method
b. can’t be used when a company has more than two service departments
c. is a simpler allocation method than the direct method
d. ignores some interdepartmental services

4. ABC can be applied to manufacturing overheads only; it is not applicable to selling and administrative overheads.

5. A major objective of activity-based management is to reduce or eliminate value-added activities.

6. Move time and storage time are examples of non-value-added costs that can be eliminated without deterioration of product quality,
performance or perceived value to the customers.

7. A tool that focuses on manufacturing process and seeks to reduce or optimize the activities performed within the process is
a. Process value analysis b. Re-engineering c. Benchmarking d. Answer not given

8. A non-value adding cost is

a. Usually direct to a product cost c. Unavoidable
b. The same as a discretionary cost d. Not essential to manufacturing a product

9. A value-added employee in a construction firm would be

a. An accountant (CPA) b. A secretary c. A painter d. All of the above

10. “Waste” is another name for

a. Non value-added costs b. Idle costs c. Trash costs d. All of the above

11. Which of the following is typically regarded as a cost driver in traditional costing practices?
a. Number of purchase order processed c. Number of transactions processed
b. Number of customers served d. Number of direct labor hours worked

12. ABC
a. requires the identification of cost drivers
b. is used only in JIT operations
c. applied only to discretionary fixed costs
d. does not help identify activities as value-adding or non-value-adding

13. The term cost driver refers to

a. any activity that can be used to predict cost changes
b. the attempt to control expenditures at a reasonable level
c. the person who gathers and transfers cost data to the management accountant
d. any activity that causes costs to be incurred

14. A cost pool is

a. all costs of a production department c. over-applied or under-applied overhead costs
b. the material and labor cost used on a particular job d. a group of overhead costs driven by the same activity

15. In ABC, preliminary cost allocations assign costs to

a. Departments b. Processes c. Products d. Activities
16. In ABC, final cost allocations assign costs to
a. Departments b. Processes c. Products d. Activities

17. Cadott Manufacturing produces three products. Production and cost information show the following:
Model X Model Y Model Z
Units produced 1,000 3,000 6,000
Direct labor hours 2,000 1,000 2,000
Number of inspections 20 30 50

Inspection costs totaled P50,000. Using direct labor hours as the allocation base, inspection costs allocated to each unit of Model X
would be
a. P5.00 b. P10.00 c. P20.00 d. Some other amount

18. Using the same data in No. 17, inspection costs allocated to each unit of Model Y using ABC would be:
a. P3.33 b. P5.00 c. P10.00 d. Some other amount

19. Genco manufactures two versions of a product. Production and cost information show the following:
Model A Model B
Units produced 100 200
Material moves 10 40
DL hours per unit 1 3

Material handling costs total P100,000. DL hours are used to allocate overhead costs. The material handling costs allocated to each
unit of Model A would be:
a. P143 b. P200 c. P333 d. Some other amount

20. Using the same data in No. 19, the material handling costs allocated to each unit of Model B using ABC would be:
a. P200 b. P333 c. P400 d. Some other amount

21. Waupaca Company produces three products with the following production and cost data:
Model A Model B Model C
Units produced 2,000 6,000 12,000
DL hours (total) 4,000 2,000 4,000
Number of setups 100 150 250
Number of shipments 200 225 275
Engineering change orders 15 10 5

Overhead costs include setups P45,000; shipping costs P70,000; and engineering costs P90,000. What would be the per unit
overhead cost for Model B if ABC were used?
a. P11.00 b. P33.00 c. P61.50 d. Some other amount

22. Kimball Company produces two products in a single factory. The following production and cost information has been determined:
Model 1 Model 2
Units produced 10,000 2,000
Material moves (total) 100 40
Testing time (total) 250 125
DL hours per unit 1 5

The controller has determined total overhead to be P480,000. P120,000 relates to material moves; P150,000 relates to testing; the
remainder is related to labor time. If Kimball uses DL hours to allocate overhead to each model, what would overhead per unit be
for Model 1?
a. P1.00 b. P12.00 c. P24.00 d. P40.00

SOLUTIONS:

17. P50,000 x (2,000/5,000) = P20,000 / 1,000 units = P20

18. P50,000 x (30/100) = P15,000 / 3,000 units = P5

19. P100,000 / [(100 x 1) + (200 x 3)] = P143

20. P100,000 x 40/50 = P80,000 / 200 = P400

21. [(P45,000 x 150/500) / 6,000] + [(P70,000 x 225/700) / 6,000] + [(P90,000 x 10/30) / 6,000] = P11.00
22. P480,000 / [(10,000 x 1) + (2,000 x 5)] = P24