© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Chapter 21 Cost Allocation and Performance Measurement

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Conceptual Learning Objectives C1: Explain departmentalization and the role of departmental accounting C2: Distinguish between direct and indirect expenses C3: Identify bases for allocating indirect expenses to departments C4: Explain controllable costs and responsibility accounting C5: Appendix 21A: Describe allocation of joint costs across products

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin A1: Analyze investment centers using return on total assets P1: Assign overhead costs using two-stage cost allocation P2: Assign overhead costs using activity-based costing P3: Prepare departmental income statements P4: Prepare departmental contribution reports Analytical Learning Objectives

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin One of the most difficult tasks in computing accurate unit costs lies in determining the proper amount of overhead cost to assign to each job. Assigning overhead is difficult. I agree! Overhead Cost Allocation Methods P1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin A two-stage process may be used because different departments may have different allocation bases. A two-stage process may be used because different departments may have different allocation bases. Finishing Department Shipping Department Painting Department Two-Stage Cost Allocation P1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3 Stage One: Costs assigned to departments Two-Stage Cost Allocation P1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Stage One: Costs assigned to departments Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3 P1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Stage One: Costs assigned to departments Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3 P1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Stage Two: Costs applied to jobs Stage One: Costs assigned to departments Jobs Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3 P1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Jobs Direct Labor Hours Machine Hours Raw Materials Cost Departmental Allocation Bases Stage Two: Costs applied to jobs Stage One: Costs assigned to departments Two-Stage Cost Allocation Indirect Materials Other Overhead Indirect Labor Department 1 Department 2 Department 3 P1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Level of Complexity Overhead Allocation Plantwide Overhead Rate Departmental Overhead Rates Activity Based Costing Activity-Based Cost Allocation P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin In the ABC method, we recognize that many activities within a department drive overhead costs. In the ABC method, we recognize that many activities within a department drive overhead costs. A BC A C B P2 Activity-Based Cost Allocation

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Identify activities and assign indirect costs to those activities. Central idea...  Products require activities.  Activities consume resources. A BC A C B Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin More detailed measures of costs. Better understanding of activities. More accurate product costs for...  Pricing decisions.  Product elimination decisions.  Managing activities that cause costs. Benefits should always be compared to costs of implementation. More detailed measures of costs. Better understanding of activities. More accurate product costs for...  Pricing decisions.  Product elimination decisions.  Managing activities that cause costs. Benefits should always be compared to costs of implementation. Activity-Based Costing Benefits P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Most cost drivers are related to either volume or complexity of production.  Examples: machine time, machine setups, purchase orders, production orders. Three factors are considered in choosing a cost driver:  Causal relationship.  Benefits received.  Reasonableness. Most cost drivers are related to either volume or complexity of production.  Examples: machine time, machine setups, purchase orders, production orders. Three factors are considered in choosing a cost driver:  Causal relationship.  Benefits received.  Reasonableness. Identifying Cost Drivers P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin  Identify activities that consume resources.  Assign costs to a cost pool for each activity.  Identify cost drivers associated with each activity.  Compute overhead rate for each cost pool:  Assign costs to products: Overhead Actual Rate Activity × Rate = Estimated overhead costs in activity cost pool Estimated number of activity units Activity-Based Costing Procedures P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Let’s look at an example comparing traditional costing with ABC. We will start with traditional costing. Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Pear Company manufactures a product in regular and deluxe models. Overhead is assigned on the basis of direct labor hours. Budgeted overhead for the current year is $2,000,000. Other information: First, determine the unit cost of each model using traditional costing methods. Traditional Costing vs. ABC Example P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Overhead Estimated overhead costs Rate Estimated activity = Overhead $2,000,000 Rate 40,000 DLH == $50 per DLH P2 Traditional Costing

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin ABC will have different overhead per unit. Traditional Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Pear Company plans to adopt activity-based costing. Using the following activity center data, determine the unit cost of the two products using activity-based costing. Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin 400 deluxe regular = 1,200 total Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Let’s complete the table. Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Total overhead = $720,000 + $1,280,000 = $2,000,000 Recall that $2,000,000 was the original amount of overhead assigned to the products using traditional overhead costing. Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Activity-Based Costing P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin This result is not uncommon when activity-based costing is used. Many companies have found that low-volume, specialized products have greater overhead costs than previously realized. Traditional Costing vs. ABC P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Costs and Cost Drivers in Activity-Based Costing Exh P2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Provide information for managers to use in performance evaluation. Assign costs to managers who are responsible for controlling the costs. Primary goals Departmental Accounting C1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Large complex businesses are divided into departments enabling managers to have a smaller effective span of control. Departmental Accounting C1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departments are established for specialized functions. Departmental Accounting C1 Production Sales Service

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Managers use this information to :  Control operations  Appraise performance  Allocate resources.  Plan strategy The accounting system provides information about resources used and outputs achieved. Information for Departmental Evaluation C1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin The type of accounting information provided depends on whether the department is a... Evaluated on ability to control costs. Evaluated on ability to generate revenues in excess of expenses. Cost center Profit center Information for Departmental Evaluation C1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Quality Customer Satisfaction Profitability Cost Effectiveness Information must support these four pillars of any successful business Information for Departmental Evaluation C1

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Direct expenses are incurred for the sole benefit of a specific department. Indirect expenses benefit more than one department and are allocated among departments benefited. Departmental Expense Allocation C2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Illustration of Indirect Expense Allocation Exh C2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Exh Illustration of Indirect Expense Allocation C2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Exh Illustration of Indirect Expense Allocation C2

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Service department costs are shared, indirect expenses that support the activities of two or more production departments. Bases for Allocating Service Department Costs Exh C3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 Service Department Costs Question C3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly? a.$100,000 b.$120,000 c.$150,000 d. $180,000 Assembly percentage = 100 ÷ ( ) = 40% 40% of $300,000 = $120,000 Service Department Costs Question C3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Preparing Departmental Income Statements P3 Let’s prepare departmental income statements using the following steps: Direct expense accumulation. Indirect expense allocation. Service department expense allocation

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Service Dept. One Service Dept. Two Operating Dept. One Direct expenses are traced to each department without allocation. Operating Dept. Two Step 1: Direct Expense Accumulation P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Service Dept. One Service Dept. Two Operating Dept. One Indirect expenses are allocated to all departments using appropriate allocation bases. Allocation Step 2: Indirect Expense Allocation Operating Dept. Two P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Operating Dept. One Operating Dept. Two Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to operating departments. Allocation Service Dept. One Service Dept. Two Step 3: Service Department Expense Allocation P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Expense Allocation Spreadsheet P3 Let’s examine this three-step allocation procedure for Owl Company.

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Expense Allocation Spreadsheet Step 1: Direct expenses are traced to service departments and sales departments without allocation. P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Expense Allocation Spreadsheet Step 2: Indirect expenses are allocated to both the service and the sales departments based on floor space occupied. Of a total of 2,000 square feet, the service departments occupy 200 square feet each, sales department one occupies 600 square feet, and sales department two occupies 1,000 square feet. P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Sales department one has $40,000 in sales and sales department two has $48,000 in sales. Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments. Departmental Expense Allocation Spreadsheet P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Expense Allocation Spreadsheet Sales department one has 28 employees and sales department two has 40 employees. Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments. P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Expense Allocation Spreadsheet P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin. Departmental Income Statements P3 Now that we have the costs, let’s do an income statement

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Income Statements P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Income Statements P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental contribution...  Is used to evaluate departmental performance.  Is not a function of arbitrary allocations of indirect expenses. A department may be eliminated when its departmental contribution is negative. Departmental revenue – Direct expenses = Departmental contribution Departmental Contribution to Overhead P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin As a general rule, a department can be considered a candidate for elimination if its revenues are less than its escapable expenses.  Direct expenses are usually escapable.  Indirect expenses are usually inescapable. Eliminating an Unprofitable Department P3

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental Contribution to Overhead P4 Let’s recast Owl Company’s income statement using the departmental contribution approach where indirect expenses are not allocated.

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Net income for the company is still $17,500. Departmental Contribution to Overhead P4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental contributions to indirect expenses (overhead) are emphasized. Departmental Contribution to Overhead P4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Departmental contributions are positive so neither department is a candidate for elimination. Departmental Contribution to Overhead P4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Costs are controllable if the manager has the power to determine, or strongly influence, the amounts incurred. A manager’s performance evaluation should be based on controllable costs. Controllable Costs C4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Direct costs are traced to departments, but may not be controllable by the department manager.  Example: Department managers usually have no control over their own salaries. Controllable costs are identified with a particular manager and a definite time period.  All costs are controllable at some level of management if the time period is long enough. Distinguishing Controllable and Direct Costs C4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin An accounting system that provides information... Responsibility Accounting Relating to the responsibilities of individual managers. To evaluate managers on controllable items. C4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Responsibility Accounting Successful implementation of responsibility accounting may use organization charts with clear lines of authority and clearly defined levels of responsibility. C4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Amount of detail varies according to level in organization. A department manager receives detailed reports. A store manager receives summarized information from each department. Responsibility Accounting Performance Reports C4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin The vice president of operations receives summarized information from each store. Management by exception: Upper-level management does not receive operating detail unless problems arise. Amount of detail varies according to level in organization. Responsibility Accounting Performance Reports C4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin To be of maximum benefit, responsibility reports should...  Be timely.  Be issued regularly.  Be understandable.  Compare budgeted and actual amounts. Responsibility Accounting Performance Reports C4

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin A single cost incurred in producing or purchasing two or more different products.  Similar to an indirect expense since it is shared among more than one cost object.  Example: The cost of crude oil is a joint cost for many petrochemical products. Joint Costs C5

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin If we allocate the joint costs of raising the animal to the two products based on weight, which product would receive the largest cost allocation? Joint Costs and Their Allocation Hamburger, because there is more of it. C5

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin If we allocate the joint costs of raising the animal to the two products based on sales value, would the steak receive a greater portion of the cost allocation? Yes, steak has a higher sales value than hamburger. Joint Costs and Their Allocation C5

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Allocate the $200,000 joint cost based on sales value. Product One Sales value = $80,000 Product Two Sales value = $200,000 Product Three Sales value = $120,000 $200,000 Joint Cost Value Basis Allocation of Joint Costs C5

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Value Basis Allocation of Joint Costs C5

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin End of Chapter 21