Two-Stage Cost Systems

Agenda Traditional cost systems Two-stage systems Examples Detroit Lofts Ross Parts Takeaway

Mapping Resources to Products Product costs arise from products’ use of resources Dedicated Resources Shared Resources More accurate costing systems Better track the products’ use of shared resources Design of more accurate costing systems 2 stage-costing systems

Traditional Cost Systems Materials Labor Overhead Direct Direct % Labor Cost Doors Mufflers Manifolds

Two Stage Cost Systems Traditional Systems Assumes that all shared resources exist to support direct labor Modern Manufacturing and Service Technologies Shared resources could include Machines and Technical Personnel Product and Service Designers Two Stage Costing Systems A more sophisticated method of mapping shared resources to individual products

Example: Detroit Lofts, Inc. A small loft at 3930 Cass Ave. in Detroit Originally a VFW bar Now houses two office spaces A and B of 600 sq. ft. and 400 sq. ft. respectively Each office space is used by one person The joint utility bill is $800, of which $500 is for heat, and $300 is for water Electricity and Comcast are billed individually What is the utility cost of each office space?

Traditional System Use square footage as the allocation basis Both offices together have 1,000 sq. ft. So each sq. ft. costs $800 ÷ 1000 = $0.80 Office costs A: $0.80 x 600 = $480 B: $0.80 x 400 = $320 Do the costs properly reflect resource use by the two offices?

Two-Stage Costing System One approach is to adopt a “two-stage” cost system First stage Split overhead into the two departments (heat and water) Second stage Calculate separate overhead rates using different allocation bases (cost drivers) Note: use allocation base levels that combine all offices’ usage Calculate individual office costs using the new rates

Two-Stage Cost System Comcast Internet Electricity Overhead Direct Heat Water Square feet Headcount Office A Office B

Detroit Lofts: Resource Usage First stage Total utilities bill is $800 = $500 (heat) + $300 (water) Second stage Heat allocated by square footage (allocation base) Heat rate = $500 ÷ (600 + 400) = $0.50 per sq.ft. Water allocated by headcount (allocation base) Water rate = $300 ÷ (1 + 1) = $150 per person Office A cost = $0.50 x 600 + $150 = $450 (down from $480) Office B cost = $0.50 x 400 + $150 = $350 (up from $320) A better reflection of the offices’ true usage of shared resources

Agenda Traditional cost systems Two-stage systems Examples Detroit Lofts Ross Parts Takeaway

Another Example: Ross Parts Ross Parts produces two products through two production departments (machining and assembly) Product 1 (“Cutting Edge”) is a new product that requires many hours in Machining Product 2 (“Old Faithful”) is a standard product that requires few hours in Machining Both products require the same time in Assembly

Ross Parts Product and cost data Old Faithful Cutting Edge Direct materials cost $30 Machine hours – Machining 1 2 Labor hours – Machining Machine hours – Assembly Labor hours – Assembly Estimated production (units) 1,000 2,000 Direct labor rate – All depts. $25/hour Overhead cost – Machining $120,000 Overhead cost – Assembly $30,000

Ross Parts Ross Parts uses a traditional cost system and allocates all overhead costs using direct labor costs What is the reported cost for the two products?

Ross Parts Product costs (per unit): Overhead rate: Total overhead cost ($120,000 + $30,000) = $150,000 Total labor cost (1,000 x 4 + 2,000 x 4) x $25 = $300,000 Overhead rate ($150,000 ÷ $300,000) = 50% Product costs (per unit): Old Faithful Cutting Edge Direct materials $30 Direct labor (@$25) 100 Overhead (@50% of labor cost) 50 Product cost $180

Do the Reported Costs Make Sense? Unit costs are the same for each product Cutting Edge “uses” twice as much of the Machining Department resources Old Faithful requires 1 machine hour per unit Cutting Edge requires 2 machine hours per unit How can we better reflect the physical resource usage?

Ross Parts Cost System Materials Labor Overhead Direct Direct 50 % Labor Cost Old Faithful: Materials $30 Labor $100 Overhead $50 Cutting Edge: Materials $30 Labor $100 Overhead $50

Two-Stage Cost System Materials Labor Overhead Direct Direct Machining Assembly Machine Hours % Labor Cost Old Faithful Cutting Edge

Two-Stage System Overhead rates: Machining Department Total overhead cost $120,000 Total machine hours (1,000 x 1 + 2,000 x 2) = 5,000 Overhead rate ($120,000 ÷ 5,000 hours) = $24/machine-hour Assembly Department Total overhead cost $30,000 Total labor cost (1,000 x 2 + 2,000 x 2) x $25 = $150,000 Overhead rate ($30,000 ÷ $150,000) = 20%

Two-Stage System Product costs Old Faithful Cutting Edge Direct materials $30 Direct labor – Machining 50 Direct labor – Assembly Overhead Machining (@$24/machine-hour) 24 48 Assembly (@20% Assembly labor) 10 Total $164 $188

Takeaway Traditional cost systems are an “easy” and intuitive approach to cost allocation Usually adequate for financial reporting However, traditional systems assume all shared resources exist to support the same input factor (e.g., direct labor) Two-stage systems More complex Offer a better mapping scheme from shared resources to products