MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

Management Accounting Cost allocations (Planning and control) Chapter 9 Management Accounting McWatters, Zimmerman, Morse

Objectives Describe the relation among common resources, indirect costs and cost objects Explain the role of allocating indirect costs for external financial reports, income tax reports and cost reimbursement Identify reasons for cost allocation for planning purposes Identify reasons for cost allocation for control purposes Describe how the various reasons for cost allocation can create conflict within the organization Allocate indirect costs using the five basic steps Create segment reports for the organization Management Accounting McWatters, Zimmerman, Morse

Allocating Indirect Costs Cost allocation is the process of assigning indirect costs to cost objects Indirect costs Cost Object Cost Allocation Allocation involves the use of cost drivers Cost drivers are events causing indirect costs Management Accounting McWatters, Zimmerman, Morse 3

Allocating Indirect Costs Cost Allocation Examples Indirect Cost Personnel Department Computer Center Factory building depreciation Maintenance Department Cost Object Operating Departments Computer users Products made in the factory Departments requesting maintenance service Indirect costs can’t be traced to a single cost object. They are associated with multiple cost objects Cost objects include products, activities, divisions, customers, suppliers, and time periods Management Accounting McWatters, Zimmerman, Morse 3

Reasons for Allocating Indirect Costs Benefits of indirect cost allocation Satisfying external reporting requirements Planning purposes Control purposes Management Accounting McWatters, Zimmerman, Morse 3

Satisfying External Requirements Allocation methods deferring indirect costs to inventory will increase profits in the current period Manufacturing Costs Inventory (Balance Sheet) Allocation methods that reduce income, reduce taxes Cost of Goods Sold (Income Statement) Management Accounting McWatters, Zimmerman, Morse

Satisfying External Requirements Not all management accounting decisions are based on internal demand for information. Organizations have responsibility to provide information to outside parties such as: Financial reports to shareholders Reporting of taxable income Cost reimbursement contracts It is common to have separate accounting systems for internal and external purposes Management Accounting McWatters, Zimmerman, Morse

Satisfying External Requirements A sports ball manufacturer makes 2 types of balls. The company is considering 2 methods of allocating indirect costs There is no beginning inventory and the manufacturer makes 20,000 soccer balls and 40,000 footballs. Indirect manufacturing costs are £100,00. During the period all the soccer balls and 30,000 of the footballs are sold. The first method allocates £80,000 to soccer balls and £20,000 to footballs and the second allocates £40,000 to soccer balls and £60,000 to footballs 25% of the footballs are not yet sold so costs associated with them remain an asset Management Accounting McWatters, Zimmerman, Morse

Satisfying External Requirements A sports ball manufacturer makes 2 types of balls. The company is considering 2 methods of allocating indirect costs Under the first method 25% of the manufacturing overhead (£5,000) is not deducted from profits Under the second method 25% of £60,000 (£15,000) is not deducted The second method causes reported profits to be higher 25% of the footballs are not yet sold so costs associated with them remain an asset Management Accounting McWatters, Zimmerman, Morse

Cost Reimbursement Contracts Indirect Manufacturing Costs Product A Product B Product B Product A is sold in a competitive market Product B is manufactured on a cost-plus contract Allocating more costs to Product B will result in more revenue from the cost-plus contract, thereby increasing profits Management Accounting McWatters, Zimmerman, Morse

Cost Reimbursement Contracts Indirect Manufacturing Costs Product A Product B Product A is sold in a competitive market Product B is manufactured on a cost-plus contract The US federal government established the Cost Accounting Standards Board to regulate cost allocations by suppliers of government agencies Management Accounting McWatters, Zimmerman, Morse

Satisfying External Requirements Numerical Example A web design firm has 2 types of clients. Those that request a cost-plus 20% contract and those that request a fixed fee of £20,000. The firm is considering 2 methods of cost allocation wishes to know which method provides a higher profit The firm completes 50 web designs of each type in the period. The average direct costs of each design are €10,000. Indirect costs are €500,000. The first method assigns €200,000 to cost plus designs and €300,000 to fixed-fee designs. The second method allocates €400,000 to cost-plus designs and €100,000 to fixed-fee designs Management Accounting McWatters, Zimmerman, Morse

Satisfying External Requirements Numerical Example Method 1 Method 2 Cost plus designs € Direct costs (50 x €10,000) 500,000 Indirect costs 200,000 Total 700,000 Total profit for both contracts Revenues Cost-plus (€700,000 x 120%) 840,000 Fixed fee (50 x €20,000) 1,000,000 1,840,000 Costs Direct (100 x €10,000) Indirect Net profit 340,000 Cost plus designs € Direct costs (50 x €10,000) 500,000 Indirect costs 400,000 Total 900,000 Total profit for both contracts Revenues Cost-plus (€900,000 x 120%) 1,080,000 Fixed fee (50 x €20,000) 1,000,000 2,080,000 Costs Direct (100 x €10,000) Indirect Net profit 580,000 Management Accounting McWatters, Zimmerman, Morse

Different Accounting Systems for External and Internal Purposes Using the same cost allocation method for external financial, tax, and cost reimbursement reports can lead to conflicts Using a different accounting system for each purpose can . . . Increase reported financial income Reduce taxable income Increase revenues from cost reimbursements Management Accounting McWatters, Zimmerman, Morse

Cost Allocation for Planning Purposes Allocation of indirect costs . . . can provide managers with information that allows them to make better decisions serves as a communication mechanism to let managers know how their actions are affecting costs elsewhere in the organization Management Accounting McWatters, Zimmerman, Morse

Communication of Costs to Improve Planning Decisions Externalities result in costs and/or benefits imposed on others (external parties) without their consent For example, additional computing capacity is an externality Management Accounting McWatters, Zimmerman, Morse

Cost Allocation for Control Reasons Cost allocations may control managers through The allocation of resources The effect of cost allocations on performance measures Management Accounting McWatters, Zimmerman, Morse

Cost Allocations and the Allocation of Resources The allocation of costs in some organizations coincides with the allocation of resources The allocated costs are like a tax Management Accounting McWatters, Zimmerman, Morse

Cost Allocations and Performance Measures Responsibility centres are evaluated based on accounting numbers These accounting numbers are influenced by the allocation of indirect costs from resources used by multiple responsibility centres Performance measures should reveal the actions of the manager being evaluated Cost allocations change behaviour within organizations Organizations should continually evaluate their cost allocation methods Management Accounting McWatters, Zimmerman, Morse

Mutual Monitoring Incentives Mutual Monitoring results when cost allocations are made from one responsibility centre to another Management Accounting McWatters, Zimmerman, Morse

Basic Steps of Cost Allocation The steps for cost allocation are . . . Defining the cost objects Accumulating indirect costs into cost pools Choosing an allocation base Estimating an application rate Allocating indirect costs based on use of the allocation base Management Accounting McWatters, Zimmerman, Morse

Defining the Cost Objects A cost object is chosen to . . . Obtain cost information for planning purposes Influence the decisions of managers for control purposes Cost objects include . . . Departments and processes Products and services Customers and suppliers Management Accounting McWatters, Zimmerman, Morse

Accumulating the Indirect Costs in Cost Pools Costs caused by the common use of a resource are accumulated in cost pools Cost pools contain all costs of the resource, both direct costs and allocated indirect costs Management Accounting McWatters, Zimmerman, Morse

Two-Stage Allocation Procedure Service Dept 1 Service Dept 2 Service Dept 3 Mfg Dept A Mfg Dept B Mfg Dept C Mfg Dept D P r o d u c t s Multi-stage allocation occurs when costs are allocated through a series of cost pools Management Accounting McWatters, Zimmerman, Morse

Choosing an Allocation Base The allocation base is a measurement of a characteristic used to distribute indirect costs of a cost pool Each pool may have a different allocation base Cost drivers of the allocation bases that costs from overhead activity cost pools to different responsibility centres The choice of the allocation base depends on the organization goals The choice of allocation base is diverse to be associated with the indirect cost Management Accounting McWatters, Zimmerman, Morse

Choosing an Allocation Base Fairness Consistency Key Objectives Of Allocation System Simplicity Management Accounting McWatters, Zimmerman, Morse

Choosing an Allocation Base Selection Criteria Allocation Base Causal Relation Benefits Received Reasonableness Management Accounting McWatters, Zimmerman, Morse

Choosing an Allocation Base Allocation Base Examples Management Accounting McWatters, Zimmerman, Morse

Choosing an Allocation Base Allocation Base Examples Management Accounting McWatters, Zimmerman, Morse

Estimating an Application Rate The application rate for an allocation base is commonly estimated at the beginning of the year using the following ratio: Estimated Dollars in the Cost Pool Application Rate = Estimated Total Usage of the Allocation Base Management Accounting McWatters, Zimmerman, Morse

Estimating an Application Rate Numerical Example A motor pool allocates costs to other departments based on the number of kilometers driven in company vehicles The motor pool expects to incur annual fixed costs of £200,000 and variable costs of £0.20 per km. The motor pool expects company vehicles to be driven a total of 800,000 km £200,000 + (£0.20/km x 800,000km = £0.45/km 800,000 km The application rate is higher than the incremental cost of operating the vehicle (£0.20/km) and thus acts like a transfer price leading the managers to choose to use other means of transportation Management Accounting McWatters, Zimmerman, Morse

Estimating an Application Rate Problem When one department decreases activity to reduce allocations, all departments are penalized because the charge per use increases Remember, total fixed costs do not change as activity changes Solutions Establish nominal per use charge so users are aware that service is not free, but not so large as to discourage legitimate use Charge a flat fee so that the per use charge declines with more uses, thereby encouraging more uses Pitfall Allocating indirect fixed costs using a variable activity allocation base Management Accounting McWatters, Zimmerman, Morse

Distributing Indirect Costs Based on Usage of the Allocation Base Indirect costs applied = Activity Rate × Actual activity Based on estimates, and determined before the period begins Actual amount of the allocation base, such as maintenance hours, incurred during the period Management Accounting McWatters, Zimmerman, Morse

Segment Reporting Segment reporting is the process of developing accounting reports for the separate units of an organization Objectives To communicate information to managers of the different segments To motivate managers to better decisions consistent with the goals of the organization Management Accounting McWatters, Zimmerman, Morse

Segment Reporting Numerical Example The Green Corporation makes chemex and citrol. The corporation has 2 product lines with separate managers. Calculate the profit of the 2 divisions The Chemex Division sells 50 tonnes of chemex for £10,000 per tonne and 20 tonnes of chemex are transferred to the Citrol Division. The Citrol Division sells 100 tonnes of citrol for £20,000. The Chemex Division has variable costs of £8,000 per tonne and fixed costs of £200,000. The Citrol Division has variable costs of £8,000 per tonne (excluding the cost of chemex) and fixed costs of £400,000. Central administration allocates £100,000 of fixed costs to Chemex Division and £500,000 of fixed costs to Citrol Division Management Accounting McWatters, Zimmerman, Morse

Estimating an Application Rate Numerical Example Chemex Division (£) Citrol Division (£) Revenues Open market sales 500,000 2,000,000 Internal sales Chemex 200,000 Variable costs Internal purchase of chemex (200,000) Other variable costs (350,000) (800,000) Contribution margin 350,000 1,000,000 Fixed costs (400,000) Profit before allocated costs 150,000 600,000 Allocated costs (100,000) (500,000) Divisional profit 50,000 100,000 Management Accounting McWatters, Zimmerman, Morse

Management Accounting Cost allocations (Planning and control) End of Chapter 9 Management Accounting McWatters, Zimmerman, Morse