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CHAPTER 66
Cost Allocation
&
Activity-Based Costing
Slide 6-2
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
To provide information for decision
making
To reduce frivolous use of common
resources
To encourage evaluation of services
To provide full cost information
Slide 6-3
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Slide 6-4
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Provide information for decision making
Allocated cost should measure the
opportunity cost of using a company resource
In practice, difficult to operationalize since
cost may quickly change
Provides a useful benchmark
Slide 6-5
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Reduce frivolous use of common resources
Frivolous use may have hidden cost such as
slower service
Allocation of centrally provided services
provides incentive for departments to reduce
frivolous use of resource
Slide 6-6
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
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
Slide 6-7
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
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,
i.e.cost-plus contracts
Slide 6-8
Cost-Plus
Cost-Plus Contracts
Contracts
Slide 6-9
Process
Process of
of Cost
Cost Allocation
Allocation
Determine the cost objective
Form cost pools
Select an allocation base to relate
cost pools to the cost objective
Slide 6-10
Process
Process of
of Cost
Cost Allocation
Allocation
Slide 6-11
Determine
Determine the
the Cost
Cost Objective
Objective
Determine the product, service, or
department that is to receive the
allocation. Object of the allocation is
called the cost objective
For example, if computer costs are
allocated to contracts, the contracts are
the cost objective
Slide 6-12
Cost
Cost Objectives
Objectives
Slide 6-13
Answer: c
The product, service or department that is to
receive the allocation
Slide 6-14
Form
Form Cost
Cost Pools
Pools
A grouping of individual costs whose total
is allocated using one allocation base
Costs in the pool must be homogeneous
(similar)
Cost pools can be organized along
-departmental lines, e.g. Maintenance,
Personnel depts.
-major activities, e.g. equipment setups,
inspections.
Slide 6-15
Select
Select an
an Allocation
Allocation Base
Base
Select an allocation base that relates cost
pool to the cost objectives
-base must be some characteristic that is
common to all of the cost objectives
-should be based on cause-and-effect
relationship
Slide 6-16
Select
Select an
an Allocation
Allocation Base
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?
Slide 6-17
Selecting
Selecting an
an Allocation
Allocation Base
Base
Slide 6-18
Slide 6-19
Fixed
Fixed Indirect
Indirect Costs
Costs
Other
Other
Approaches
Approaches
Relative benefits approach to allocation
- More costs allocated to those objectives that
benefit most from incurring the cost
Slide 6-20
Allocating
Allocating Service
Service Department
Department
Costs
Costs
Organizational units of manufacturing
firms classified as either:
- production departments, or
- service departments
Cost pools
- formed by service departments
- Allocated to production departments
Slide 6-21
Direct
Direct Method
Method of
of Allocating
Allocating
Service
Service Department
Department Costs
Costs
Service department costs allocated to production
departments but not to other service departments
Slide 6-22
Direct
Direct Method
Method
Mason
Mason Furniture
Furniture
Allocate janitorial cost of $100,000
Allocation base: square feet
Assembly Dept: 20,000 square feet
Finishing Dept: 30,000 square feet
Slide 6-23
Direct
Direct Method
Method
Mason
Mason Furniture
Furniture
Allocate personnel cost of $200,000
Allocation base: number of employees
Assembly Dept: 60 employees
Finishing Dept: 40 employees
Slide 6-24
Direct
Direct Method
Method
Mason
Mason Furniture
Furniture
Slide 6-26
Slide 6-27
Slide 6-28
Allocating
Allocating Budgeted
Budgeted and
and Actual
Actual
Service
Service Department
Department Costs
Costs
Management should allocate based on
budgeted costs rather than actual costs
Allocation of actual amounts allows service
department to pass on cost of inefficiencies
and waste to production departments
Slide 6-31
Problems
Problems with
with Cost
Cost Allocation
Allocation
Potential problems brought about by:
1. Allocations of costs that are not
controllable
2. Arbitrary allocations
3. Allocation of fixed costs that make the
fixed costs appear to be variable costs
4. Allocations of mfg. overhead to products
using too few overhead cost pools
5. Use of only volume related allocation bases
Slide 6-32
Responsibility
Responsibility Accounting
Accounting and
and
Controllable
Controllable Costs
Costs
Responsibility accounting
Identifies those responsible for generating
revenue and controlling costs
Slide 6-33
Arbitrary
Arbitrary Allocations
Allocations
Cost allocations are inherently arbitrary
Typically there are numerous allocation
bases that are equally justifiable
- Managers support the allocation which
makes them look best
- Managers reject allocations which cast an
unfavorable light on their performance
Slide 6-34
Unitized
Unitized Fixed
Fixed Costs
Costs and
and
Lump
Lump Sum
Sum Allocations
Allocations
Unitized fixed costs
- Fixed costs are stated on a per unit basis and
allocated as a variable cost
- Perception of costs as variable could alter
decision making
Lump-sum allocations
- Allocate predetermined amount of fixed costs
that is not affected by level of activity
- Allocation must appear to be fixed to
managers of departments receiving charge
Slide 6-35
Too
Too Few
Few Cost
Cost Pools
Pools
Although simple, may lead to distortion of
cost allocation, i.e. some products will be
overcosted or undercosted
Product costs will be more accurate when
more overhead cost pools are used
Must analyze cost-benefit relationship of
more cost pools
Slide 6-37
Problem
Problem of
of Using
Using Measures
Measures of
of Production
Production
Volume
Volume to
to Allocate
Allocate Overhead
Overhead
Typical allocation bases include direct
labor hours and machine hours
Assumes all overhead costs are
proportional to production volume
When OH costs not proportional to
production volume:
- High-volume products are overcosted
- Low-volume products are undercosted
Slide 6-38
Using
Using Only
Only Volume-Related
Volume-Related
Allocation
Allocation Bases
Bases
Some firms allocate manufacturing
overhead based on volume, e.g. direct
labor or machine hours
Not all overhead costs vary with volume
Activity-based costing (ABC) solves this
problem
Slide 6-39
Activity-Based
Activity-Based Costing
Costing
Identifies major activities that cause
overhead costs to be incurred
Cost of resources consumed performing
these activities grouped into cost pools
Costs are assigned to products using a
measure of activity, i.e. cost driver
Slide 6-40
The
The ABC
ABC Approach
Approach
Slide 6-41
Common
Common Activities
Activities and
and
Associated
Associated Cost
Cost Drivers
Drivers
Slide 6-42
Activity
Activity Based
Based CostingCostingMcMaster
McMaster Screen
Screen Technologies
Technologies
Slide 6-43
Slide 6-44
Slide 6-45
Allocation Rates:
Equipment setups = $150 per setup
Inspections = $200 per inspection
Slide 6-46
Allocation Rates:
Equipment setups = $150 per setup
Inspections = $200 per inspection
Slide 6-47
Benefits
Benefits of
of ABC
ABC
Provide more accurate costing
- Less likely to undercost/overcost due to cost
driver usage
Slide 6-48
Limitations
Limitations of
of ABC
ABC
More costly to develop and maintain than
a traditional costing system
Used to develops full cost of products
- Includes fixed costs
- Lacks incremental information
necessary for decision making
Slide 6-49
Fixed
Fixed and
and Variable
Variable Costs
Costs
Slide 6-50
Activity-Based
Activity-Based Management
Management
Activity analysis aimed at improving
efficiency and effectiveness of business
processes
ABC focus is on measuring cost of
products and services
ABM focus is on goal of managing the
activities themselves
Slide 6-51
Activity-Based
Activity-Based Management
Management
Slide 6-52
Activity-Based
Activity-Based Management
Management
Determine major activities
Identify resources used by each
activity
Evaluate the performance of the
activities
Identify ways to improve the efficiency
and/or effectiveness of the activities
Slide 6-53
Cost
Cost Allocation
Allocation and
and Decision
Decision
Making
Making
Slide 6-54
Copyright
Copyright
2010 John Wiley & Sons, Inc. All rights
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Slide 6-55