Cost Allocation and Activity-Based Costing Managerial Accounting Chapter 10 Cost Allocation and Activity-Based Costing Managerial Accounting 8th Edition Warren Reeve Fess © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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After studying this chapter, you should be able to: 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. After studying this chapter, you should be able to:

Objectives 5. Use activity-based costing to allocate selling and administrative expenses to products. 6. Use activity-based costing in a service business.

Product Costing Allocation Methods Plantwide Overhead Rate Single Rate Multiple Department Rates Department Department Activity-Based Costing Activity Activity

Single Plantwide Factory Overhead Rate

Computing Single Plantwide Factory Overhead Total budgeted factory overhead costs Total budgeted plantwide allocation base $80 per hour overhead rate $1,600,000 20,000 direct labor hours =

Computing Single Plantwide Factory Overhead Snowmobile: $80 per dlh x 10 direct labor hours = $800 Factory Overhead cost per unit Lawnmower: $80 per dlh x 10 direct labor hours = $800

Plantwide factory overhead $1,600,000 $80 per direct labor hour Snowmobile $800 per unit x 10 direct labor hours Lawnmower $800 per unit x 10 direct labor hours

The greatest advantage of the single plantwide overhead rate is that it is simple and inexpensive to apply.

Multiple Production Department Factory Overhead Rate Method

Plantwide factory overhead Single Plantwide Rate Plantwide factory overhead Plantwide rate Products

Multiple Production Department Rate Fabrication Department factory overhead Assembly Department factory overhead Assembly Department factory overhead rate Fabrication Department factory overhead rate Products

Production Department Factory Overhead Rates and Allocation Fabrication Department Overhead Rate: $1,030,000 10,000 direct labor hours = $103 per hour Assembly Department Overhead Rate: $570,000 10,000 direct labor hours = $57 per hour

Production Department Factory Overhead Rates and Allocation Snowmobile: Fabrication: $103 x 8 dlh = $824 Assembly: $57 x 2 dlh = 114 $938 Lawnmower: Fabrication: $103 x 2 dlh = $206 Assembly: $57 x 8 dlh = 456 $662

Multiple Production Department Rate Method—Ruiz Company Fabrication Department $1,030,000 Assembly Department $570,000 $103 x 8 dlh $57 x 2 dlh $938 per unit

Multiple Production Department Rate Method—Ruiz Company Fabrication Department $1,030,000 Assembly Department $570,000 $57 x 8 dlh $103 x 2 dlh $662 per unit

Distortion in Product Costs—Single Plantwide versus Multiple Production Department Overhead Rates Factory Overhead Cost per Unit Single Plantwide Rate Multiple Production Department Rates Snowmobile $800 $938 Lawnmower 800 662

Distortion in Product Costs—Single Plantwide versus Multiple Production Department Overhead Rates The single plantwide factory overhead rate distorts product cost by averaging high and low factory overhead costs.

Conditions for Product Cost Distortion—Ruiz Company Fabrication Department Assembly Department Condition 1: Differences in production department factory overhead rates $103 per direct labor hour $57 per direct labor hour Continued

Conditions for Product Cost Distortion—Ruiz Company Differences in the ratios of allocation-base usage 8 direct labor hours 2 direct labor hours

Activity-Based Costing Method Activity-based costing changes the way overhead costs are allocated. When identifying specific activities, inefficiencies may be discovered and eliminated, reducing the product’s cost. Traditional cost accounting undercosts complex products and overstates their profit margins. ABC may be used for decision making but not necessarily for inventory valuation.

Production Department Rates Multiple Production Department Factory Overhead versus ABC Production Department Factory Overhead Production Department Factory Overhead Products Production Department Rates Continued

Multiple Production Department Factory Overhead versus ABC Activity Activity Activity Activity Products Activity Rates

Activity-Based Costing Method Activity Amount Activity Rate Fabrication $ 530,000 Assembly 70,000 Setup 480,000 Quality control 312,000 Engineering 208,000 Total $1,600,000

Activity-Based Costing Method Activity Amount Activity Rate Fabrication $ 530,000 ÷ 10,000 dlh = $53 Assembly 70,000 ÷ 10,000 dlh = $7 Setup 480,000 ÷ 120 setups = $4,000 Quality control 312,000 ÷ 104 inspts. = $3,000 Engineering 208,000 ÷ 16 changes = $13,000 Total $1,600,000 Cost Drivers Snowmobile 8,000 $53 $424,000 Lawnmower 2,000 53 106,000 Total 10,000 $530,000 Fabrication: DL Hours Rate Total

Activity-Based Costing Method Activity Amount Activity Rate Fabrication $ 530,000 ÷ 10,000 dlh = $53 Assembly 70,000 ÷ 10,000 dlh = $7 Setup 480,000 ÷ 120 setups = $4,000 Quality control 312,000 ÷ 104 inspts. = $3,000 Engineering 208,000 ÷ 16 changes = $13,000 Total $1,600,000 Snowmobile 2,000 $7 $14,000 Lawnmower 8,000 7 56,000 Total 10,000 $70,000 Assembly: DL Hours Rate Total

Activity-Based Costing Method Activity Amount Activity Rate Fabrication $ 530,000 ÷ 10,000 dlh = $53 Assembly 70,000 ÷ 10,000 dlh = $7 Setup 480,000 ÷ 120 setups = $4,000 Quality control 312,000 ÷ 104 inspts. = $3,000 Engineering 208,000 ÷ 16 changes = $13,000 Total $1,600,000 Snowmobile 100 $4,000 $400,000 Lawnmower 20 4,000 80,000 Total 120 $480,000 Setup: Setups Rate Total

Activity-Based Costing Method Activity Amount Activity Rate Fabrication $ 530,000 ÷ 10,000 dlh = $53 Assembly 70,000 ÷ 10,000 dlh = $7 Setup 480,000 ÷ 120 setups = $4,000 Quality control 312,000 ÷ 104 inspts. = $3,000 Engineering 208,000 ÷ 16 changes = $13,000 Total $1,600,000 Snowmobile 100 $3,000 $300,000 Lawnmower 4 3,000 12,000 Total 104 $312,000 Quality Control: Inspts. Rate Total

Activity-Based Costing Method Activity Amount Activity Rate Fabrication $ 530,000 ÷ 10,000 dlh = $53 Assembly 70,000 ÷ 10,000 dlh = $7 Setup 480,000 ÷ 120 setups = $4,000 Quality control 312,000 ÷ 104 inspts. = $3,000 Engineering 208,000 ÷ 16 changes = $13,000 Total $1,600,000 Snowmobile 12 $13,000 $156,000 Lawnmower 4 13,000 52,000 Total 16 $208,000 Engineering: Changes Rate Total

Activity-Based Costing Method Cost Allocation Summary: Activity Snowmobile Mower Total Fabrication $ 424,000 $106,000 $ 530,000 Assembly 14,000 56,000 70,000 Setup 400,000 80,000 480,000 Quality control 300,000 12,000 312,000 Engineering 156,000 52,000 208,000 Total $1,294,000 $306,000 $1,600,000 Budgeted units 1,000 1,000 Cost per unit $1,294 $306

Activity-Based Costing Method—Ruiz Company Quality Control Inspection Activity $312,000 Engineering Change Activity $208,000 Fabrication Activity $530,000 Assembly Activity $70,000 Setup Activity $480,000 $53 per dlh $7 per dlh $4,000 per setup $3,000 per inspection $13,000 per engineering change $1,294 per unit $306 per unit

Factory Overhead Cost per Unit— Three Cost Allocation Methods Distortion in Product Costs—Multiple Production Department Factory Overhead Rate Method versus Activity-Based Costing Factory Overhead Cost per Unit— Three Cost Allocation Methods Single Plantwide Multiple Production Rate Department Rates ABC Snowmobile $ 800 $ 938 $1,294 Lawnmower 800 662 306

Activity-Based Costing for Selling and Administrative Activities Selling and administrative activities may include: 1. Post-sale technical support 2. Order writing 3. Promotional support 4. Order entry 5. Customer return processing 6. Shipping document preparation 7. Shipping and handling 8. Field service

$200 per operating room hour Activity-Based Costing in Service Businesses Hopewell Hospital—Activity-Based Costing Admitting $180 per admission P A T I E N S Radiological Testing $320 per image $200 per operating room hour Operating Room Pathological Testing $120 per specimen Dietary and Laundry $150 per day

$200 per operating room hour Activity-Based Costing in Service Businesses P A T I E N S Hopewell Hospital—Activity-Based Costing Admitting Radiological Testing Operating Room Pathological Dietary and Laundry $180 per admission $320 per image $200 per operating room hour $120 per specimen $150 per day Cost Budget $960,000 Estimated Activity 3,000 images Radiological Testing Activity Rate: = $320 =

Activity Costs Allocated to a Patient Patient Name: Mary Wilson Activity-Base Activity Activity Activity Usage Rate Cost Admitting 1 admission $180 $ 180 Radiology testing 2 images 320 640 Operating room 4 hours 200 800 Pathological testing 1 specimen 120 120 Dietary and laundry 7 days 150 1,050 Total $2,790 x = The overhead cost associated with services can be related to the customers that use the service.

Customer Profitability Report Hopewell Hospital Customer (Patient) Profitability Report For the Period Ending December 31, 2006 Adcock, Kim Birini, Brian Conway, Don Wilson, Mary Revenues $9,500 $21,400 $5,050 $3,300 Less: Patient costs Drugs and supplies $ 400 $ 1,000 $ 300 $ 200 Admitting 180 180 180 180 Radiological testing 1,280 2,560 1,280 640 Operating room 2,400 6,400 1,600 800 Pathological testing 240 600 120 120 Dietary and laundry 4,200 14,700 1,050 1,050 Total patient costs $8,700 $25,440 $4,530 $2,990 Income from operations $ 800 $ (4,040) $ 520 $ 310

Chapter 10 The End