1. MANAGEMENT ACCOUNTING
Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

2. Management Accounting Cost allocations (Planning and control)
Chapter 9
Management Accounting McWatters, Zimmerman, Morse

3. Objectives
Describe the relation among common resources, indirect costs and cost objects
Explain the role of allocating indirect costs for external financial reports, income tax reports and cost reimbursement
Identify reasons for cost allocation for planning purposes
Identify reasons for cost allocation for control purposes
Describe how the various reasons for cost allocation can create conflict within the organization
Allocate indirect costs using the five basic steps
Create segment reports for the organization
Management Accounting McWatters, Zimmerman, Morse

4. Allocating Indirect Costs
Cost allocation is the process of assigning indirect costs to cost objects
Indirect costs
Cost Object
Cost Allocation
Allocation involves the use of cost drivers
Cost drivers are events causing indirect costs
Management Accounting McWatters, Zimmerman, Morse 3

5. Allocating Indirect Costs
Cost Allocation Examples
Indirect Cost
Personnel Department
Computer Center
Factory building depreciation
Maintenance Department
Cost Object
Operating Departments
Computer users
Products made in the factory
Departments requesting maintenance service
Indirect costs can’t be traced to a single cost object. They are associated with multiple cost objects
Cost objects include products, activities, divisions, customers, suppliers, and time periods
Management Accounting McWatters, Zimmerman, Morse 3

6. Reasons for Allocating Indirect Costs
Benefits of indirect cost allocation
Satisfying external reporting requirements
Planning purposes
Control purposes
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7. Satisfying External Requirements
Allocation methods deferring indirect costs to inventory will increase profits in the current period
Manufacturing Costs
Inventory (Balance Sheet)
Allocation methods that reduce income, reduce taxes
Cost of Goods Sold (Income Statement)
Management Accounting McWatters, Zimmerman, Morse

8. Satisfying External Requirements
Not all management accounting decisions are based on internal demand for information. Organizations have responsibility to provide information to outside parties such as:
Financial reports to shareholders
Reporting of taxable income
Cost reimbursement contracts
It is common to have separate accounting systems for internal and external purposes
Management Accounting McWatters, Zimmerman, Morse

9. Satisfying External Requirements
A sports ball manufacturer makes 2 types of balls. The company is considering 2 methods of allocating indirect costs
There is no beginning inventory and the manufacturer makes 20,000 soccer balls and 40,000 footballs. Indirect manufacturing costs are £100,00. During the period all the soccer balls and 30,000 of the footballs are sold. The first method allocates £80,000 to soccer balls and £20,000 to footballs and the second allocates £40,000 to soccer balls and £60,000 to footballs
25% of the footballs are not yet sold so costs associated with them remain an asset
Management Accounting McWatters, Zimmerman, Morse

10. Satisfying External Requirements
A sports ball manufacturer makes 2 types of balls. The company is considering 2 methods of allocating indirect costs
Under the first method 25% of the manufacturing overhead (£5,000) is not deducted from profits
Under the second method 25% of £60,000 (£15,000) is not deducted
The second method causes reported profits to be higher
25% of the footballs are not yet sold so costs associated with them remain an asset
Management Accounting McWatters, Zimmerman, Morse

11. Cost Reimbursement Contracts
Indirect Manufacturing Costs
Product A
Product B
Product B
Product A is sold in a competitive market
Product B is manufactured on a cost-plus contract
Allocating more costs to Product B will result in more revenue from the cost-plus contract, thereby increasing profits
Management Accounting McWatters, Zimmerman, Morse

12. Cost Reimbursement Contracts
Indirect Manufacturing Costs
Product A
Product B
Product A is sold in a competitive market
Product B is manufactured on a cost-plus contract
The US federal government established the Cost Accounting Standards Board to regulate cost allocations by suppliers of government agencies
Management Accounting McWatters, Zimmerman, Morse

13. Satisfying External Requirements Numerical Example
A web design firm has 2 types of clients. Those that request a cost-plus 20% contract and those that request a fixed fee of £20,000. The firm is considering 2 methods of cost allocation wishes to know which method provides a higher profit
The firm completes 50 web designs of each type in the period. The average direct costs of each design are €10,000. Indirect costs are €500,000. The first method assigns €200,000 to cost plus designs and €300,000 to fixed-fee designs. The second method allocates €400,000 to cost-plus designs and €100,000 to fixed-fee designs
Management Accounting McWatters, Zimmerman, Morse

14. Satisfying External Requirements Numerical Example
Method 1
Method 2
Cost plus designs €
Direct costs (50 x €10,000)
500,000
Indirect costs
200,000
Total
700,000
Total profit for both contracts
Revenues
Cost-plus (€700,000 x 120%)
840,000
Fixed fee (50 x €20,000)
1,000,000
1,840,000
Costs
Direct (100 x €10,000)
Indirect
Net profit
340,000
Cost plus designs €
Direct costs (50 x €10,000)
500,000
Indirect costs
400,000
Total
900,000
Total profit for both contracts
Revenues
Cost-plus (€900,000 x 120%)
1,080,000
Fixed fee (50 x €20,000)
1,000,000
2,080,000
Costs
Direct (100 x €10,000)
Indirect
Net profit
580,000
Management Accounting McWatters, Zimmerman, Morse

15. Different Accounting Systems for External and Internal Purposes
Using the same cost allocation method for external financial, tax, and cost reimbursement reports can lead to conflicts
Using a different accounting system for each purpose can . . .
Increase reported financial income
Reduce taxable income
Increase revenues from cost reimbursements
Management Accounting McWatters, Zimmerman, Morse

16. Cost Allocation for Planning Purposes
Allocation of indirect costs . . .
can provide managers with information that allows them to make better decisions
serves as a communication mechanism to let managers know how their actions are affecting costs elsewhere in the organization
Management Accounting McWatters, Zimmerman, Morse

17. Communication of Costs to Improve Planning Decisions
Externalities result in costs and/or benefits imposed on others (external parties) without their consent
For example, additional computing capacity is an externality
Management Accounting McWatters, Zimmerman, Morse

18. Cost Allocation for Control Reasons
Cost allocations may control managers through
The allocation of resources
The effect of cost allocations on performance measures
Management Accounting McWatters, Zimmerman, Morse

19. Cost Allocations and the Allocation of Resources
The allocation of costs in some organizations coincides with the allocation of resources
The allocated costs are like a tax
Management Accounting McWatters, Zimmerman, Morse

20. Cost Allocations and Performance Measures
Responsibility centres are evaluated based on accounting numbers
These accounting numbers are influenced by the allocation of indirect costs from resources used by multiple responsibility centres
Performance measures should reveal the actions of the manager being evaluated
Cost allocations change behaviour within organizations
Organizations should continually evaluate their cost allocation methods
Management Accounting McWatters, Zimmerman, Morse

21. Mutual Monitoring Incentives
Mutual Monitoring results when cost allocations are made from one responsibility centre to another
Management Accounting McWatters, Zimmerman, Morse

22. Basic Steps of Cost Allocation
The steps for cost allocation are . . .
Defining the cost objects
Accumulating indirect costs into cost pools
Choosing an allocation base
Estimating an application rate
Allocating indirect costs based on use of the allocation base
Management Accounting McWatters, Zimmerman, Morse

23. Defining the Cost Objects
A cost object is chosen to . . .
Obtain cost information for planning purposes
Influence the decisions of managers for control purposes
Cost objects include . . .
Departments and processes
Products and services
Customers and suppliers
Management Accounting McWatters, Zimmerman, Morse

24. Accumulating the Indirect Costs in Cost Pools
Costs caused by the common use of a resource are accumulated in cost pools
Cost pools contain all costs of the resource, both direct costs and allocated indirect costs
Management Accounting McWatters, Zimmerman, Morse

25. Two-Stage Allocation Procedure
Service Dept 1
Service Dept 2
Service Dept 3
Mfg Dept A
Mfg Dept B
Mfg Dept C
Mfg Dept D
P r o d u c t s
Multi-stage allocation occurs when costs are allocated through a series of cost pools
Management Accounting McWatters, Zimmerman, Morse

26. Choosing an Allocation Base
The allocation base is a measurement of a characteristic used to distribute indirect costs of a cost pool
Each pool may have a different allocation base
Cost drivers of the allocation bases that costs from overhead activity cost pools to different responsibility centres
The choice of the allocation base depends on the organization goals
The choice of allocation base is diverse to be associated with the indirect cost
Management Accounting McWatters, Zimmerman, Morse

27. Choosing an Allocation Base
Fairness
Consistency
Key Objectives Of
Allocation System
Simplicity
Management Accounting McWatters, Zimmerman, Morse

28. Choosing an Allocation Base
Selection Criteria
Allocation Base
Causal Relation
Benefits Received
Reasonableness
Management Accounting McWatters, Zimmerman, Morse

29. Choosing an Allocation Base
Allocation Base Examples
Management Accounting McWatters, Zimmerman, Morse

30. Choosing an Allocation Base
Allocation Base Examples
Management Accounting McWatters, Zimmerman, Morse

31. Estimating an Application Rate
The application rate for an allocation base is commonly estimated at the beginning of the year using the following ratio:
Estimated Dollars in the Cost Pool
Application Rate =
Estimated Total Usage of the Allocation Base
Management Accounting McWatters, Zimmerman, Morse

32. Estimating an Application Rate Numerical Example
A motor pool allocates costs to other departments based on the number of kilometers driven in company vehicles
The motor pool expects to incur annual fixed costs of £200,000 and variable costs of £0.20 per km. The motor pool expects company vehicles to be driven a total of 800,000 km
£200,000 + (£0.20/km x 800,000km =
£0.45/km
800,000 km
The application rate is higher than the incremental cost of operating the vehicle (£0.20/km) and thus acts like a transfer price leading the managers to choose to use other means of transportation
Management Accounting McWatters, Zimmerman, Morse

33. Estimating an Application Rate
Problem
When one department decreases activity to reduce allocations, all departments are penalized because the charge per use increases
Remember, total fixed costs do not change as activity changes
Solutions
Establish nominal per use charge so users are aware that service is not free, but not so large as to discourage legitimate use
Charge a flat fee so that the per use charge declines with more uses, thereby encouraging more uses
Pitfall
Allocating indirect fixed costs using a variable activity allocation base
Management Accounting McWatters, Zimmerman, Morse

34. Distributing Indirect Costs Based on Usage of the Allocation Base
Indirect costs applied = Activity Rate × Actual activity
Based on estimates, and determined before the period begins
Actual amount of the allocation base, such as maintenance hours, incurred during the period
Management Accounting McWatters, Zimmerman, Morse

35. Segment Reporting
Segment reporting is the process of developing accounting reports for the separate units of an organization
Objectives
To communicate information to managers of the different segments
To motivate managers to better decisions consistent with the goals of the organization
Management Accounting McWatters, Zimmerman, Morse

36. Segment Reporting Numerical Example
The Green Corporation makes chemex and citrol. The corporation has 2 product lines with separate managers. Calculate the profit of the 2 divisions
The Chemex Division sells 50 tonnes of chemex for £10,000 per tonne and 20 tonnes of chemex are transferred to the Citrol Division. The Citrol Division sells 100 tonnes of citrol for £20,000. The Chemex Division has variable costs of £8,000 per tonne and fixed costs of £200,000. The Citrol Division has variable costs of £8,000 per tonne (excluding the cost of chemex) and fixed costs of £400,000. Central administration allocates £100,000 of fixed costs to Chemex Division and £500,000 of fixed costs to Citrol Division
Management Accounting McWatters, Zimmerman, Morse

37. Estimating an Application Rate Numerical Example
Chemex Division (£)
Citrol Division (£)
Revenues
Open market sales
500,000
2,000,000
Internal sales Chemex
200,000
Variable costs
Internal purchase of chemex
(200,000)
Other variable costs
(350,000)
(800,000)
Contribution margin
350,000
1,000,000
Fixed costs
(400,000)
Profit before allocated costs
150,000
600,000
Allocated costs
(100,000)
(500,000)
Divisional profit
50,000
100,000
Management Accounting McWatters, Zimmerman, Morse

38. Management Accounting Cost allocations (Planning and control)
End of Chapter 9
Management Accounting McWatters, Zimmerman, Morse