c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Allocation and Activity- Based Costing Chapter 11

Learning Objectives 1. Identify three methods used for allocating factory overhead costs to products. 2. Use a single plantwide factory overhead rate for product costing. 3. Use multiple production department factory overhead rates for product costing. 4. Use activity-based costing for product costing. 5. Use activity-based costing to allocate selling and administrative expenses to products. 6. Use activity-based costing in a service business.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Identify three methods used for allocating factory overhead costs to products. 1

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Product Costing Allocation Methods o Most companies have accounting systems that trace revenues to individual product lines. In addition, they need to subtract the cost of manufacturing their products from revenues in order to determine the profit from sales. Determining the cost of a product is termed product costing.

P RODUCT C OSTING A LLOCATION M ETHODS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Product Costing Allocation Methods o Three methods of allocating factory overhead costs are:  Single plantwide factory overhead rate method  Multiple production department factory overhead rate method  Activity-based costing method

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use a single plantwide factory overhead rate for product costing. 2

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Single Plantwide Factory Overhead Rate Method o Under the single plantwide factory overhead rate method, all of the factory overhead is allocated to all products using only one rate.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Ruiz Company Illustration o Ruiz Company manufactures two products, snowmobiles and riding mowers. Both products are manufactured in a single factory. There is $1,600,000 of factory overhead budgeted for the period. Ruiz Company

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Ruiz Company Illustration o Each product is budgeted 10,000 direct labor hours as shown below: Ruiz Company

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Total Budgeted Factory Overhead Costs Total Budgeted Plantwide Allocation Base $80 per direct labor hour $80 per direct labor hour = $1,600,000 20,000 direct labor hours (1,000 × 10 dlh) + (1,000 × 10 dlh) Ruiz Company Illustration o The single plantwide rate is calculated as follows: Ruiz Company

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Factory Overhead Cost per Unit Ruiz Company Ruiz Company Illustration o Snowmobile:  $80 per dlh × 10 direct labor hours = $800 o Riding Mower:  $80 per dlh × 10 direct labor hours = $800

R UIZ C OMPANY I LLUSTRATION

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Single Plantwide Factory Overhead Rate Method o The primary advantage of the single plantwide overhead rate method is that it is simple and inexpensive to apply in practice.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use multiple production department factory overhead rates for product costing. 3

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Multiple Production Department Factory Overhead Rate Method o The multiple production department factory overhead rate method uses different rates for each production department to allocate factory overhead costs to products.

M ULTIPLE P RODUCTION D EPARTMENT F ACTORY O VERHEAD R ATE M ETHOD

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. $1,030,000 10,000 direct labor hours $103 per dlh = $103 per dlh $570,000 10,000 direct labor hours $57 per dlh = $57 per dlh Department Overhead Rates and Allocation o Fabrication Department Factory Overhead Rate: o Assembly Department Factory Overhead Rate: Ruiz Company

D EPARTMENT O VERHEAD R ATES AND A LLOCATION

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Distortion of Product Costs o The differences in factory overhead for each product using the two methods are shown below: Ruiz Company

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Distortion of Product Costs o The following conditions indicate that a single plantwide factory overhead rate may cause product cost distortions:  Condition 1: Differences in production department factory overhead rates.  Condition 2: Differences among products in the ratios of allocation base usage within a department and across departments.

D ISTORTION OF P RODUCT C OSTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use activity-based costing for product costing. 4

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity-Based Costing Method o The activity-based costing method provides an alternative approach for allocating factory overhead that uses multiple factory overhead rates based on different activities. o Activities are the types of work, or actions, involved in a manufacturing or service process.

A CTIVITY -B ASED C OSTING M ETHOD

Fabrication$ 530,000 Assembly70,000 Setup480,000 Quality-control inspections312,000 Engineering changes 208,000 Total budgeted activity costs$1,600,000 Activity Budgeted Activity Cost Cutting metal to shape the product Manually assembling machined pieces Changing tooling in machines in preparation for making a new product Inspecting the product for conformity to specifications An engineering change order (ECO) initiates changing a product or process. A CTIVITY -B ASED C OSTING M ETHOD Ruiz Company

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity Rate = Budgeted Activity Cost Total Activity-Base Usage Activity Rates and Allocation o The budgeted activity costs are assigned to products using factory overhead rates for each activity. These rates are called activity rates because they are related to activities.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity Rates and Allocation o The term activity base, rather than allocation base, is used because the base is related to an activity.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity-Based Costing Method o Snowmobiles are a new product for Ruiz Company, and engineers are still making minor design changes. Riding mowers have been produced by Ruiz Company for many years. Ruiz Company

A CTIVITY -B ASED C OSTING M ETHOD

Ruiz Company A CTIVITY -B ASED C OSTING M ETHOD

Snowmobile 8,000$53$424,000 Riding Mower 2, ,000 Total10,000$530,000 Fabrication:DL HoursRateTotal A CTIVITY -B ASED C OSTING M ETHOD

Snowmobile2,000$7$14,000 Riding Mower 8, ,000 Total10,000$70,000 Assembly:DL HoursRateTotal A CTIVITY -B ASED C OSTING M ETHOD

Snowmobile100$4,000$400,000 Riding Mower 204,000 80,000 Total120$480,000 Setup:SetupsRateTotal A CTIVITY -B ASED C OSTING M ETHOD

Snowmobile100$3,000$300,000 Riding Mower 43,000 12,000 Total104$312,000 Quality Control:Inspts.RateTotal A CTIVITY -B ASED C OSTING M ETHOD

Snowmobile12$13,000$156,000 Riding mowers 413,000 52,000 Total16$208,000 Engineering:ChangesRateTotal A CTIVITY -B ASED C OSTING M ETHOD

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Distortion of Product Costs o Comparison of the Three Allocation Methods Ruiz Company

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Ruiz Company Distortion of Product Costs o If Ruiz Company used the $800 factory overhead cost allocation (single plantwide rate) instead of activity-based costing, the following would likely result:  The snowmobile would be underpriced because its factory overhead cost is understated by $494 ($1,294 – $800).  The riding mower would be overpriced because its factory overhead cost is overstated by $494 ($800 – $306).

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use activity-based costing to allocate selling and administrative expenses to products. 5

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Abacus Company Activity-Based Costing for Selling and Administrative Expenses o Abacus Company has two products, Ipso and Facto. Both products have the same total sales volume. The selling and administrative expenses of Abacus Company are allocated to its two products on the basis of sales volume. However, Ipso and Facto consume selling and administrative activities differently, as shown in Exhibit 11 (next slide).

A CTIVITY -B ASED C OSTING FOR S ELLING AND A DMINISTRATIVE E XPENSES

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity-Based Costing for Selling and Administrative Expenses

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity-Based Costing for Selling and Administrative Expenses o Assuming that Ipso had 10 warranty claims and Facto had 90 warranty claims, the field service activity expenses would be allocated as follows:  Ipso: $15,000 = 10 warranty claims x $1,500 per warranty claim  Facto: $135,000 = 90 warranty claims x $1,500 per warranty claim

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use activity-based costing in a service business. 6

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Hopewell Hospital Activity-Based Costing in Service Businesses o Hopewell Hospital uses an activity-based costing system to determine how hospital overhead is allocated to patients. Each activity shown in Exhibit 12 (next slide) has an estimated patient activity-base usage.

A CTIVITY -B ASED C OSTING IN S ERVICE B USINESSES

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Activity Rate = Budgeted Activity Cost Total Activity Base Usage Radiological Testing Activity Rate $960,000 3,000 images = $320 per image = $320 per image Activity-Based Costing in Service Businesses o The budgeted costs for radiological testing are $960,000, based on total estimated activity- base usage of 3,000 images.

Hopewell Hospital A CTIVITY -B ASED C OSTING IN S ERVICE B USINESSES

Hopewell Hospital A CTIVITY -B ASED C OSTING IN S ERVICE B USINESSES

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Allocation and Activity- Based Costing The End