Cost Allocation and Activity Based Costing Chapter Six Cost Allocation and Activity Based Costing

Reasons for Allocating versus Assigning Costs Direct costs can be assigned to cost objects - example material in a shirt Indirect costs must be allocated to cost objects – example: part of depreciation on garment factory to be assigned to shirt Costs must be allocated for GAAP product costing, but for managerial purposes only do when productive

Allocation Costs for Product Costing For GAAP financial statements, all costs associated with production, including fixed and variable overhead, must be captured in inventory. In order to do this, we use a predetermined overhead application rate to assign costs to production.

Allocating for Managerial Accounting Purposes For managerial accounting (internal reporting) we are not governed by the rules of GAAP so the question is how to use allocations to get the most useful information and/or the best motivation. A cost may be allocated for one purpose but not for another. For example, you might allocate to evaluate a segment, but not it’s manager.

The Allocation Process Assume that we have $120,000 in building costs that are going to be assigned to the 3 departments in the business building based on number of faculty. The departments have 30, 10, and 20 faculty. How much should each be assigned?

Basic Allocation Example

Using Actual Rates - the Wrong Way Assume that two departments use power from the electric generating department. Generating department has a cost formula of $10,000 + $0.10/KWHr Dept. A’s peak needs are 100,000 hours, and B’s peak needs are 50,000 hours. During December, A used 40,000 hours, B used 50,000 and total cost was $21,000.

Actual Allocation How much would each department get charged if the actual charges are assigned to each based on the actual relative usage? Would you want this number on your performance report - can you control it?

Dual Allocation Dual allocation recognizes that the need for capacity in a given resource drives the fixed costs of the resource, while the utilization of capacity drives the variable costs. Also believes that charges to managers that will be involved in performance evaluation should be dependent on quantity of resource used by manager (be controllable) and be predictable.

Dual Allocation - the fair way Try to come up with an allocation for A and B that will make what is charged not dependent on what the other uses, will not pass along inefficiency in the power dept. to the operating departments, and will make each department pay the fixed costs associated with its demand for capacity (peak needs).

Service Department Cost Allocation In order to get full production costs, the costs of service departments in factories have to be first assigned to the producing departments, and then assigned to the products. We use the direct method, where the service department costs are assigned directly to the producing departments.

Direct Method of Allocating Service Department Costs The Direct Method.

Direct Method of Allocating Service Department Costs Example:

Activity-Based Costing (ABC) Approach ABC assigns costs to products based on the resource usage of each product. Volume is one major driver of resource usage, but other drivers may be as or more important. Accountants today recognize two other major influences on cost, complexity and diversity of operations. ABC is concerned with resource consumption. ABC identifies multiple cost pools and drivers for each.

Activity-Based Costing Terms Activities are the processes that organizations undertake that create costs Cost Drivers are measures of the level of activity. Cost Pools are groups of activity costs that are able to use the same cost driver.

MultiBrick Cost Determination Data Traditional Approach Total manufacturing overhead $800,000 Total output 10,000,000 bricks Model A-42 Model A-88 Model C-11 Total production 600,000 400,000 9,000,000 Material cost per brick $0.05 $0.04 $0.03 Direct labor cost per brick $0.06 $0.07 $0.04 Overhead rate = $800,000 / 10,000,000 = $0.08 per brick

MultiBrick Cost Determination Data Traditional Approach Cost calculations: Model A-42 Model A-88 Model C-11 Material cost per brick $0.05 $0.04 $0.03 Direct labor cost per brick 0.06 0.07 0.04 Overhead cost at $0.08 0.08 0.08 0.08 Total unit cost $0.19 $0.19 $0.15

MultiBrick Data for Illustration ABC Approach Cost Drivers Cost in Pool Level of Driver Rate Setups $120,000 10,000 setups $12 Baking time 600,000 300,000 hours $2 Customer orders 80,000 5,000 orders $16 $800,000

MultiBrick Activity Data per Year Model A-42 Model A-88 Model C-11 Number of setups 1500 1800 6700 baking time, hours 60,000 50,000 190,000 Number of customer orders 300 400 4,300 Costs, excluding overhead Material cost per brick $0.05 $0.04 $0.03 Direct labor cost per brick 0.06 0.07 0.04

MultiBrick ABC Analysis of Bricks Model A-42 Model A-88 Model C-11 Overhead: Setup-based 18,000 21,600 80,400 Baking time 120,000 100,000 380,000 Customer order based 4,800 6,400 68,800 Total OH $142,800 $128,000 $529,200 Material cost $30,000 $16,000 $270,000 Direct labor cost 36,000 28,000 360,000 Total Cost $208,800 $172,000 $1159,200 Divided by annual volume 600,000 400,000 9,000,000 Average cost per brick $0.35 $0.43 $0.1288

Comparison of Traditional Costs and ABC Traditional Cost Approach: Model A-42 Model A-88 Model C-11 Material cost per brick $0.05 $0.04 $0.03 Direct labor cost per brick 0.06 0.07 0.04 Overhead cost at $0.08 0.08 0.08 0.08 Total unit cost $0.19 $0.19 $0.15 ABC Cost Approach: Material cost $0.05 $0.04 $0.03 Overhead 0.24 0.32 0.06 Total cost 0.35 0.43 0.13

Consumption Ratios Consumption ratios is the resource utilized by a given product divided by the total amount of the resource available. Since MultiBrick is producing a total of 10,000,000 bricks, the consumption ratio of each model is: Model A-42: 600,000 bricks / 10,000,000 = 6% Model A-88: 400,000 bricks / 10,000,000 = 4% Model C-11: 9,000,000 bricks / 10,000,000 = 90% High volume products use unit based drivers at higher levels than non-unit based drivers.

Conclusions about ABC Using ABC will normally lower the cost of the high volume, easy to manufacture product Using ABC will raise the cost of the low volume specialty product to show what it really costs the firms to produce Managers will make better decisions with better information Managers will manage based on how they are evaluated - you get what you measure!

Activity-Based Management (ABM) Activity-Based Management (ABM)is using information about activities to manage many aspects of an organization, rather than simply managing costs.

ABM (continued) Determine major activities Identify the resources used by each activity Evaluate the performance of the activity Identify ways to improve the efficiency and or effectiveness of the activity