Cost Allocation and Activity-Based Costing Student Version

Identify three methods used for allocating factory overhead costs to products. 26-2

Most companies have accounting systems that trace revenues to individual product lines. In addition, they need to subtract the cost of manufacturing their product from revenues in order to determine the profit from sales. Determining the cost of the product is termed product costing. Product Costing 1

Product Costing Allocation Methods 1

Use a single plantwide factory overhead rate for product costing. 26-5

Ruiz Company Illustration Ruiz Company manufactures two products, snowmobiles and lawnmowers. Both products are manufactured in a single factory. There is $1,600,000 of factory overhead budgeted for the period. 2

Ruiz Company Illustration Each product is budgeted 10,000 direct labor hours as shown below:

Total budgeted factory overhead costs Total budgeted plantwide allocation base Computing Single Plantwide Factory Overhead $80 per direct labor hour = $1,600,000 20,000 direct labor hours (1,000 × 10 dlh) + (1,000 × 10 dlh) 2

Snowmobile: $80 per dlh × 10 direct labor hours = $800 Lawnmower: $80 per dlh × 10 direct labor hours = $800 Factory Overhead Cost per Unit 2 Computing Single Plantwide Factory Overhead

Use multiple production department factory overhead rates for product costing

Production Department Factory Overhead Rates and Allocation Fabrication Department Overhead Rate: $1,030,000 10,000 direct labor hours = $103 per dlh Assembly Department Overhead Rate: $570,000 10,000 direct labor hours = $57 per dlh 3

Allocating Factory Overhead to Products—Ruiz Company Exhibit 3 3

Exhibit 4 Multiple Production Department Rate Method—Ruiz Company

Distortion of Product Costs The differences in factory overhead for each product using the two methods are shown below: 3

In general, the following conditions may indicate that a single plantwide factory overhead rate will lead to distorted product costs. Condition 1: Differences in production department factory overhead rates. (continued) 3 Condition 2: Differences among products in the ratios of allocation base usage within a department and across departments.

Exhibit 5 Conditions for Product Cost Distortion—Ruiz Company 3

Use activity-based costing for product costing

The activity-based costing (ABC) method focuses on the cost of activities and then allocates these costs to products using a variety of activity bases. Activity-Based Costing (ABC) Method 4

Fabrication$ 530,000 Assembly70,000 Setup480,000 Quality control inspections312,000 Engineering changes 208,000 Total budgeted factory overhead costs$1,600,000 Activity Cost PoolAmount Ruiz Company Example 4

Activity Rates The activity cost pools are assigned to products, using factory overhead rates for each activity. These rates are called activity rates. Activity Rate = Budgeted Activity Cost Activity Base 4

Additional Data About the Two Products (continued) 4

Additional Data About the Two Products

Exhibit 7 Activity Bases—Ruiz Company 4

Exhibit 8 Activity Rates—Ruiz Company Snowmobile 8,000$53$424,000 Lawnmower 2, ,000 Total10,000$530,000 Fabrication:DL HoursRateTotal 4 (continued)

Snowmobile2,000$7$14,000 Lawnmower 8, ,000 Total10,000$70,000 Assembly:DL HoursRateTotal 4 Exhibit 8 Activity Rates—Ruiz Company (continued)

Exhibit 8 Activity Rates—Ruiz Company Snowmobile100$4,000$400,000 Lawnmower 204,000 80,000 Total120$480,000 Setup:SetupsRateTotal (continued)

Exhibit 8 Activity Rates—Ruiz Company (continued) Snowmobile100$3,000$300,000 Lawnmower 43,000 12,000 Total104$312,000 Quality Control:Inspts.RateTotal

Exhibit 8 Activity Rates—Ruiz Company Snowmobile12$13,000$156,000 Lawnmower 413,000 52,000 Total16$208,000 Engineering:ChangesRateTotal

Exhibit 9 Activity-Based Product Cost Calculations 4

Additional Data About the Two Products 4

Use activity-based costing to allocate selling and administrative expenses to products

The selling and administrative expenses of Abacus Company are allocated to its two products, Ipso and Facto, on the basis of warranty claims. Abacus Company has a budgeted cost of $150,000. One hundred warranty claims are estimated for the period. Abacus Company Example 5

Warranty Claim Activity Rate = Budgeted Warranty Claim Expenses Estimated Warranty Claims Warranty Claim Activity Rate = $150, claims Warranty Claim Activity Rate = $1,500 per claim 5