1. Two-Stage Cost Systems

2. Agenda Traditional cost systems Two-stage systems Examples
Detroit Lofts
Ross Parts
Takeaway

3. Mapping Resources to Products
Product costs arise from products’ use of resources
Dedicated Resources
Shared Resources
More accurate costing systems
Better track the products’ use of shared resources
Design of more accurate costing systems
2 stage-costing systems

4. Traditional Cost Systems
Materials
Labor
Overhead
Direct
Direct
% Labor Cost
Doors
Mufflers
Manifolds

5. Two Stage Cost Systems Traditional Systems
Assumes that all shared resources exist to support direct labor
Modern Manufacturing and Service Technologies
Shared resources could include
Machines and Technical Personnel
Product and Service Designers
Two Stage Costing Systems
A more sophisticated method of mapping shared resources to individual products

6. Example: Detroit Lofts, Inc.
A small loft at 3930 Cass Ave. in Detroit
Originally a VFW bar
Now houses two office spaces A and B of 600 sq. ft. and 400 sq. ft. respectively
Each office space is used by one person
The joint utility bill is $800, of which $500 is for heat, and $300 is for water
Electricity and Comcast are billed individually
What is the utility cost of each office space?

7. Traditional System Use square footage as the allocation basis
Both offices together have 1,000 sq. ft.
So each sq. ft. costs $800 ÷ 1000 = $0.80
Office costs
A: $0.80 x 600 = $480
B: $0.80 x 400 = $320
Do the costs properly reflect resource use by the two offices?

8. Two-Stage Costing System
One approach is to adopt a “two-stage” cost system
First stage
Split overhead into the two departments (heat and water)
Second stage
Calculate separate overhead rates using different allocation bases (cost drivers)
Note: use allocation base levels that combine all offices’ usage
Calculate individual office costs using the new rates

9. Two-Stage Cost System Comcast Internet Electricity Overhead Direct
Heat
Water
Square
feet
Headcount
Office A
Office B

10. Detroit Lofts: Resource Usage
First stage
Total utilities bill is $800 = $500 (heat) + $300 (water)
Second stage
Heat allocated by square footage (allocation base)
Heat rate = $500 ÷ ( ) = $0.50 per sq.ft.
Water allocated by headcount (allocation base)
Water rate = $300 ÷ (1 + 1) = $150 per person
Office A cost = $0.50 x $150 = $450 (down from $480)
Office B cost = $0.50 x $150 = $350 (up from $320)
A better reflection of the offices’ true usage of shared resources

11. Agenda Traditional cost systems Two-stage systems Examples
Detroit Lofts
Ross Parts
Takeaway

12. Another Example: Ross Parts
Ross Parts produces two products through two production departments (machining and assembly)
Product 1 (“Cutting Edge”) is a new product that requires many hours in Machining
Product 2 (“Old Faithful”) is a standard product that requires few hours in Machining
Both products require the same time in Assembly

13. Ross Parts Product and cost data Old Faithful Cutting Edge
Direct materials cost
$30
Machine hours – Machining 1 2
Labor hours – Machining
Machine hours – Assembly
Labor hours – Assembly
Estimated production (units)
1,000
2,000
Direct labor rate – All depts.
$25/hour
Overhead cost – Machining
$120,000
Overhead cost – Assembly
$30,000

14. Ross Parts
Ross Parts uses a traditional cost system and allocates all overhead costs using direct labor costs
What is the reported cost for the two products?

15. Ross Parts Product costs (per unit): Overhead rate:
Total overhead cost
($120,000 + $30,000) =
$150,000
Total labor cost
(1,000 x 4 + 2,000 x 4) x $25 =
$300,000
Overhead rate
($150,000 ÷ $300,000) =
50%
Product costs (per unit):
Old Faithful
Cutting Edge
Direct materials
$30
Direct labor
100
Overhead of labor cost) 50
Product cost
$180

16. Do the Reported Costs Make Sense?
Unit costs are the same for each product
Cutting Edge “uses” twice as much of the Machining Department resources
Old Faithful requires 1 machine hour per unit
Cutting Edge requires 2 machine hours per unit
How can we better reflect the physical resource usage?

17. Ross Parts Cost System Materials Labor Overhead Direct Direct
50 % Labor Cost
Old Faithful:
Materials $30
Labor $100
Overhead $50
Cutting Edge:
Materials $30
Labor $100
Overhead $50

18. Two-Stage Cost System Materials Labor Overhead Direct Direct Machining
Assembly
Machine
Hours
% Labor
Cost
Old Faithful
Cutting Edge

19. Two-Stage System Overhead rates: Machining Department
Total overhead cost
$120,000
Total machine hours
(1,000 x 1 + 2,000 x 2) =
5,000
Overhead rate
($120,000 ÷ 5,000 hours) =
$24/machine-hour
Assembly Department
Total overhead cost
$30,000
Total labor cost
(1,000 x 2 + 2,000 x 2) x $25 =
$150,000
Overhead rate
($30,000 ÷ $150,000) =
20%

20. Two-Stage System Product costs Old Faithful Cutting Edge
Direct materials
$30
Direct labor – Machining 50
Direct labor – Assembly
Overhead
Machining 24 48
Assembly Assembly labor) 10
Total
$164
$188

21. Takeaway
Traditional cost systems are an “easy” and intuitive approach to cost allocation
Usually adequate for financial reporting
However, traditional systems assume all shared resources exist to support the same input factor (e.g., direct labor)
Two-stage systems
More complex
Offer a better mapping scheme from shared resources to products