Cost Accounting Allocation of Overhead MB-664 May 2009

Managerial Cost Concepts 1.Direct materials 1.Direct materials: raw materials physically associated with the final product 2.Direct labor 2.Direct labor: employees physically and directly associated with the final product 3.Overhead 3.Overhead: variable manufacturing overhead tied directly to the final product while fixed manufacturing overhead is not. 4.Selling and administrative 4.Selling and administrative: Marketing expenses, office expenses and managerial salaries and benefits.

Sales Budget Production Budget Direct Materials Budget Direct Materials Budget Direct Labor Budget Direct Labor Budget Overhead Budget Overhead Budget Selling and Administrative Expense Budget Selling and Administrative Expense Budget Budgeted Income Statement Budgeted Income Statement Budgeted Cash Flow Statement Budgeted Balance Sheet Budgeted Balance Sheet Budgets and Financial Statements Capital expenditures Capital expenditures Cash Budget

Sales Budget Production Budget Direct Materials Budget Direct Materials Budget Direct Labor Budget Direct Labor Budget Overhead Budget Overhead Budget Enterprise Budgets and The Master Budget Enterprise #1 Unit sales and expected price Unit production and inventory Direct materials used Direct labor used Manufacturing overhead Enterprise #n Unit sales and expected price Unit production and inventory Direct materials used Direct labor used Manufacturing overhead

Sales Budget Production Budget Direct Materials Budget Direct Materials Budget Direct Labor Budget Direct Labor Budget Overhead Budget Overhead Budget Enterprise #1 Unit sales and expected price Unit production and inventory Direct materials used Direct labor used Manufacturing overhead Enterprise #n Unit sales and expected price Unit production and inventory Direct materials used Direct labor used Manufacturing overhead Enterprise Budgets and The Master Budget

Enterprise #1 Unit sales and expected price Unit production and inventory Direct materials used Direct labor used Manufacturing overhead Examples of direct materials: Purchase of corn. Purchase of natural gas. Purchase of other inputs used in the ethanol production process. Examples of manufacturing overhead: Variable manufacturing overhead examples include utilities, repairs and maintenance. Fixed manufacturing overhead examples include property taxes, rent, insurance premiums, depreciation and legal and professional charges. Enterprise Budgets and The Master Budget

Use of ABC Accounting activities 1.Identify and classify activities and allocate overhead to cost pools. cost drivers 2.Identify cost drivers – correlation between driver and use. ABC rates 3.Calculate overhead rates or ABC rates. 4.Assign overhead costs to products – use of cost drivers. 5.Allocate overhead to individual products.

Overhead Costs Activity Based Cost Allocation

Overhead Costs Ordering and Receiving Materials Cost Pool Ordering and Receiving Materials Cost Pool Setting Up Machines Cost Pool Setting Up Machines Cost Pool Machining Cost Pool Machining Cost Pool Assembly Cost Pool Assembly Cost Pool Inspecting and Testing Cost Pool Inspecting and Testing Cost Pool Painting Cost Pool Painting Cost Pool These are activity cost pools Activity Based Cost Allocation

Overhead Costs Ordering and Receiving Materials Cost Pool Ordering and Receiving Materials Cost Pool Setting Up Machines Cost Pool Setting Up Machines Cost Pool Machining Cost Pool Machining Cost Pool # of Purchase orders # of Purchase orders Assembly Cost Pool Assembly Cost Pool Inspecting and Testing Cost Pool Inspecting and Testing Cost Pool Painting Cost Pool Painting Cost Pool # of Setups # of Setups # of Machine hours # of Machine hours # of Parts # of Parts # of Tests # of Tests # of Direct hours # of Direct hours Activity cost pools: These are cost drivers Activity Based Cost Allocation

Overhead Costs Ordering and Receiving Materials Cost Pool Ordering and Receiving Materials Cost Pool Setting Up Machines Cost Pool Setting Up Machines Cost Pool Machining Cost Pool Machining Cost Pool # of Purchase orders # of Purchase orders Assembly Cost Pool Assembly Cost Pool Inspecting and Testing Cost Pool Inspecting and Testing Cost Pool Painting Cost Pool Painting Cost Pool # of Setups # of Setups # of Machine hours # of Machine hours # of Parts # of Parts # of Tests # of Tests # of Direct hours # of Direct hours Products Activity cost pools: Cost drivers: Activity Based Cost Allocation

Example of ABC Accounting Step 1: calculate the ABC Overhead rate: Activity Cost Pool Process Driver AB overhead overhead activity rate Setting up machines$300,000 1,500 setups $200/setup Machining$500,000 50,000 hours $10/hour Inspecting$100,000 2,000 inspection $50/inspection Total$900,000 Divide the process overhead by level of driver activity to calculate the ABC overhead rate. Divide the process overhead by level of driver activity to calculate the ABC overhead rate.

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost PoolCost driver Driver Product 1 Product 2 activity Setting up machines# setups 1, ,000 MachiningHours 50,000 30,000 20,000 Inspecting# inspections 2, ,500 Allocate the activity levels to the 2 products. For example, 500 of the setups are associated with product 1. Allocate the activity levels to the 2 products. For example, 500 of the setups are associated with product 1.

Step 2: Assigning overhead driver activity to products: Activity Cost PoolCost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, ,000 Machining Hours 50,000 30,000 20,000 Inspecting# inspections 2, ,500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines$300,000 (33%) $100,000 (67%) $200,000 Machining$500,000 (60%) $300,000 (40%) $200,000 Inspecting$100,000 (25%) $25,000 (75%) $75, /1,500 x $300,000 or 500 units x $200/setup Example of ABC Accounting

Step 2: Assigning overhead driver activity to products: Activity Cost PoolCost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, ,000 Machining Hours 50,000 30,000 20,000 Inspecting# inspections 2, ,500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines$300,000 (33%) $100,000 (67%) $200,000 Machining$500,000 (60%) $300,000 (40%) $200,000 Inspecting$100,000 (25%) $25,000 (75%) $75,000 1,000/1,500 x $300,000 or 1,000 x $200/setup Example of ABC Accounting

Step 2: Assigning overhead driver activity to products: Activity Cost PoolCost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, ,000 Machining Hours 50,000 30,000 20,000 Inspecting# inspections 2, ,500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines$300,000 (33%) $100,000 (67%) $200,000 Machining$500,000 (60%) $300,000 (40%) $200,000 Inspecting$100,000 (25%) $25,000 (75%) $75,000 30,000/50,000 x $500,000 or 30,000 x $10/hour Example of ABC Accounting

Step 2: Assigning overhead driver activity to products: Activity Cost PoolCost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, ,000 Machining Hours 50,000 30,000 20,000 Inspecting# inspections 2, ,500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines$300,000 (33%) $100,000 (67%) $200,000 Machining$500,000 (60%) $300,000 (40%) $200,000 Inspecting$100,000 (25%) $25,000 (75%) $75,000 20,000/50,000 x $500,000 or 20,000 x $10/hour Example of ABC Accounting

Step 2: Assigning overhead driver activity to products: Activity Cost PoolCost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, ,000 Machining Hours 50,000 30,000 20,000 Inspecting# inspections 2, ,500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines$300,000 (33%) $100,000 (67%) $200,000 Machining$500,000 (60%) $300,000 (40%) $200,000 Inspecting$100,000 (25%) $25,000 (75%) $75, /2,000 x $100,000 or 500 x $50/inspection Example of ABC Accounting

Step 2: Assigning overhead driver activity to products: Activity Cost PoolCost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, ,000 Machining Hours 50,000 30,000 20,000 Inspecting# inspections 2, ,500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines$300,000 (33%) $100,000 (67%) $200,000 Machining$500,000 (60%) $300,000 (40%) $200,000 Inspecting$100,000 (25%) $25,000 (75%) $75,000 1,500/2,000 x $100,000 or 1,500 x $50/inspection Example of ABC Accounting

Step 3: Partitioning of process overhead: Overhead Product 1 Product 2 Setting up machines$300,000 $100,000$200,000 Machining$500,000 $300,000$200,000 Inspecting$100,000 $25,000 $75,000 Total$900,000 $425,000 $475,000 Step 4: Process overhead costs per unit: Units produced25,000 5,000 Process overhead cost per unit $17 $95 $17 = $425,000 / 25,000 $95 = $475,000 / 5,000 $17 = $425,000 / 25,000 $95 = $475,000 / 5,000 Example of ABC Accounting

Step 3: Partitioning of process overhead: Overhead Product 1 Product 2 Setting up machines$300,000 $100,000$200,000 Machining$500,000 $300,000$200,000 Inspecting$100,000 $25,000 $75,000 Total$900,000 $425,000 $475,000 Step 4: Process overhead costs per unit: Units produced25,000 5,000 Process overhead cost per unit $17 $95 Traditional process overhead cost per unit $30 $30 Example of ABC Accounting $30 = $900,000 / (25, ,000)

Product 1 Product 2 COP unit costs with ABC costing: Direct materials $40 $30 Direct labor $12 $12 ABC manufacturing overhead $17 $95 Total unit costs $69 $137 COP unit costs with traditional costing: Direct materials $40 $30 Direct labor $12 $12 Traditional manufacturing overhead $30 $30 Total unit costs $82 $72 Traditional overhead costing suggests that Product 2 is cheaper to produce than Product 1, which is not true! Example of ABC Accounting