1. 14 - 1 Cost Allocation, Customer- Profitability Analysis, and Sales-Variance Analysis Chapter 14

2. 14 - 2 Learning Objective 1 Identify four purposes for allocating costs to cost objects.

3. 14 - 3 Purposes of Cost Allocation 1. To provide information for economic decisions 2. To motivate managers and other employees 3. To justify costs or compute reimbursement 4. To measure income and assets for reporting to external parties

4. 14 - 4 Learning Objective 2 Guide cost-allocation decisions using appropriate criteria.

5. 14 - 5 Criteria to Guide Cost-Allocation Decisions Cause-and-effect: Using this criterion, managers identify the variable or variables that cause resources to be consumed. Benefits-received: Using this criterion, managers identify the beneficiaries of the outputs of the cost object.

6. 14 - 6 Criteria to Guide Cost-Allocation Decisions Fairness or equity: This criterion is often cited on government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers. Ability to bear: This criterion advocates allocating costs in proportion to the cost object’s ability to bear them.

7. 14 - 7 Role of Dominant Criteria The cause-and-effect and the benefits- received criteria guide most decisions related to cost allocations. Fairness and ability to bear are less frequently used. Why?

8. 14 - 8 Role of Dominant Criteria Fairness is an especially difficult criterion to obtain agreement on. The ability to bear criterion raises issues related to cross-subsidization across users of resources in an organization.

9. 14 - 9 Learning Objective 3 Discuss decisions faced when collecting costs in indirect-cost pools.

10. 14 - 10 Cost Allocation and Costing Systems Example Smith Corporation manufactures clothes washers and dryers in two divisions: Clothes Washer Division in Canton (CWD) Clothes Dryer Division in Dayton (CDD)

11. 14 - 11 Cost Allocation and Costing Systems Example Corporate costs: Treasury$ 600,000 Human resources$1,200,000 Administration$4,800,000 Treasury cost is interest to finance equipment acquisition of $4,000,000 in Canton and $2,000,000 in Dayton.

12. 14 - 12 Cost Allocation and Costing Systems Example Division costs: Canton Dayton Direct costs$2,200,000$4,000,000 Indirect costs 1,980,000 2,500,000 Total$4,180,000$6,500,000

13. 14 - 13 Cost Allocation and Costing Systems Example If Smith Corporation allocates corporate costs to divisions, how many cost pools should it use to allocate corporate costs? One single cost pool? Numerous individual corporate cost pools? A key factor is the concept of homogeneity. Which allocation basis should Smith Corporation use to allocate treasury costs?

14. 14 - 14 Cost Allocation and Costing Systems Example Treasury costs: $600,000 Canton Division: $600,000 × ($4,000,000 ÷ $6,000,000) = $400,000 Dayton Division: $600,000 × ($2,000,000 ÷ $6,000,000) = $200,000

15. 14 - 15 Cost Allocation and Costing Systems Example Smith Corporation allocates human resources on the basis of total direct labor costs incurred in each division. Suppose direct labor costs in Canton are $1,200,000 and $1,800,000 in Dayton. How does Smith Corporation allocate its $1,200,000 of human resources costs?

16. 14 - 16 Cost Allocation and Costing Systems Example Canton Division: $1,200,000 × ($1,200,000 ÷ $3,000,000) = $480,000 Dayton Division: $1,200,000 × ($1,800,000 ÷ $3,000,000) = $720,000 Smith does not allocate corporate administration costs to the divisions.

17. 14 - 17 Cost Allocation and Costing Systems Example Canton Dayton Treasury costs: $600,000 ( 2/3 and 1/3) $400,000$200,000 Human resources costs: $1,200,000 40% and 60% 480,000 720,000 Total allocated to divisions$880,000$920,000

18. 14 - 18 Cost Allocation and Costing Systems Example Treasury costs are reallocated by the divisions to Assembly. Human resources costs are reallocated by the divisions to the Dept. of Human Resources.

19. 14 - 19 Cost Allocation and Costing Systems Example Canton Division Finishing direct costs: $900,000 Assembly direct costs$1,300,000 Corporate costs 400,000 Total costs$1,700,000

20. 14 - 20 Cost Allocation and Costing Systems Example Canton Division Maintenance direct costs: $300,000 Human Resources direct costs:$1,680,000 Corporate costs: 480,000 Total costs$2,160,000

21. 14 - 21 Cost Allocation and Costing Systems Example Canton Division $5,060,000 Assembly Dept. $1,700,000 Finishing Dept. $900,000 Maintenance Dept. $300,000 Human Resources Dept. $2,160,000

22. 14 - 22 Learning Objective 4 Discuss why a company’s revenues can differ across customers purchasing the same product.

23. 14 - 23 Customer Revenue Analysis Example During the first six months of 2003, English Languages Institute expanded its market and sold 200 composition programs to two new customers in Mexico. Customer A is in Tijuana and customer B is in Guadalajara.

24. 14 - 24 Customer Revenue Analysis Example Customer AB Programs sold 140 60 List selling price $185 $185 Invoice price $175 $180 Total revenues$24,500$10,800 What explanation(s) can be given for these revenue differences?

25. 14 - 25 Customer Revenue Analysis Example 1. The volume of programs purchased 2. The magnitude of price discounting

26. 14 - 26 Customer Cost Analysis Example Assume that English Languages Institute has an activity-based costing system that focuses on customers rather than products. Activity AreaCost Driver and Rate Order taking$ 80 per purchase Order set up$100 per batch

27. 14 - 27 Customer Cost Analysis Example Customer A Customer B Number of: Purchase orders 7 2 Batches 7 2 What is the cost of servicing each customer?

28. 14 - 28 Customer Cost Analysis Example Customer A: Ordering:7 × $80/order=$ 560 Set-up:7 × $100/batch= 700 Total$1,260 English can use this information to persuade this customer to reduce usage of the ordering and setup cost drivers.

29. 14 - 29 Customer Cost Analysis Example Customer B: Ordering:2 × $80/order=$160 Setup:2 × $100/batch= 200 Total$360

30. 14 - 30 Learning Objective 5 Apply the concept of cost hierarchy to customer costing.

31. 14 - 31 Cost Hierarchy General Motors uses a seven-level cost hierarchy to analyze profitability. The aim of this cost hierarchy is to assign costs to the lowest level of the hierarchy at which they can be identified.

32. 14 - 32 Cost Hierarchy 1. Enterprise-related activities 2. Market-related activities 3. Channel-related activities 4. Customer-related activities 5. Order-related activities 6. Parts-related activities 7. Direct materials

33. 14 - 33 Learning Objective 6 Discuss why customer-profitability differs across customers.

34. 14 - 34 Customer-Profitability Profiles Which customer is more profitable, A or B? A B Revenues$24,500$10,800 Cost of good sold ($95 per unit) 13,300 5,700 Contribution margin $11,200$ 5,100 Other expenses 1,260 360 Operating income$ 9,940$ 4,740

35. 14 - 35 Customer-Profitability Profiles Customer A seems to be more profitable. However, customer B has a higher gross profit percentage. Customer A has a gross profit of 40.6% ($9,940 ÷ $24,500). Customer B has a gross profit of 43.9% ($4,740 ÷ $10,800).

36. 14 - 36 Learning Objective 7 Provide additional information about the sales-volume variance by calculating the sales-mix variance and the sales-quantity variance.

37. 14 - 37 Sales-Volume Variance Components The following information relates to English Languages Institute budget for the year 2003. Product Grammar Trans. Comp. Selling price per unit$259 $87$185 Variable cost 189 50 95 Contribution margin per unit$ 70 $37$ 90

38. 14 - 38 Sales-Volume Variance Components ProductGrammarTranslationComposition Cont. margin$70$37$90 × Units3,185980735 = Total$222,950$36,260$66,150 Sales mix65%20%15% Total budgeted contribution margin = $325,360

39. 14 - 39 Sales-Volume Variance Components ProductGrammarTranslationComposition Selling $/unit$255$85$185 Variable cost 180 45 95 Cont. margin per unit $ 75$40$ 90 The following are the actual results for English Languages for the year 2003.

40. 14 - 40 Sales-Volume Variance Components ProductGrammarTranslationComposition Cont. margin$75$40$90 × Units2,880990630 = Total$216,000$39,600$56,700 Sales mix64%22%14% Total actual contribution margin = $312,300

41. 14 - 41 Static-Budget Variance Static- Static- Actual budget budget Product results amount variance Grammar$216,000$222,950$ 6,950 U Translation 39,600 36,260 3,340 F Composition 56,700 66,150 9,450 U Total$312,300$325,360$13,060 U

42. 14 - 42 Flexible-Budget Variance Actual contribution Unit Actual Product margin/unit volume results Grammar$752,880$216,000 Translation$40 990$ 39,600 Composition$90 630$ 56,700

43. 14 - 43 Flexible-Budget Variance Budgeted Actual contribution unit Flexible Product margin/unit volume budget Grammar$702,880$201,600 Translation$37 990$ 36,630 Composition$90 630$ 56,700

44. 14 - 44 Flexible-Budget Variance Flexible-Flexible- Actual budget budget Product results amount variance Grammar$216,000$201,600$14,400 F Translation$39,600 $ 36,630$ 2,970 F Composition$56,700 $ 56,700 0 Total flexible-budget variance$17,370 F

45. 14 - 45 Sales-Volume Variance Budgeted contribution Product Actual Budget margin Grammar(2,880 – 3,185) × $70 =$21,350 U Translation (990 – 980) × $37 = 370 F Composition (630 – 735) × $90 = 9,450 U Total sales-volume variance$30,430 U

46. 14 - 46 Sales-Mix Variance Sales-mix variance Actual units of all products sold Actual sales-mix percentage – Budgeted sales-mix percentage Budgeted contribution margin per unit = × ×

47. 14 - 47 Sales-Mix Variance Grammar: 4,500(0.64 – 0.65) × $70 = $3,150 U Translation: 4,500(0.22 – 0.20) × $37 = $3,330 F Composition: 4,500(0.14 – 0.15) × $90 = $4,050 U Total sales-mix variance = $3,870 U

48. 14 - 48 Sales-Quantity Variance Sales-quantity variance Actual units of all products sold – Budgeted units of all products sold Budgeted sales-mix percentage Budgeted contribution margin per unit = × ×

49. 14 - 49 Sales-Quantity Variance Grammar: (4,500 – 4,900) × 0.65 × $70= $18,200 U Translation: (4,500 – 4,900) × 0.20 × $37= $ 2,960 U Composition: (4,500 – 4,900) × 0.15 × $90= $ 5,400 U Total sales-quantity variance= $26,560 U

50. 14 - 50 Learning Objective 8 Provide additional information about the sales-quantity variance by calculating the market-share variance and the market-size variance.

51. 14 - 51 Market-Share Variance Example Assume that English Languages Institute derives its total unit sales budget for 2003 from a management estimate of a 20% market share and a total industry sales forecast by Desert Services of 24,500 units in the region. In 2003, Desert Services reported actual industry sales of 28,125 units.

52. 14 - 52 Market-Share Variance Example What is English’s actual market share? 4,500 ÷ 28,125 = 0.16 Budgeted total contribution margin is $325,360. Budgeted number of units is 4,900. What is the budgeted average contribution margin per unit? $325,360 ÷ 4,900 = $66.40

53. 14 - 53 Market-Share Variance Example What is the market-share variance? Actual market size in units Actual market share – Budgeted market share Budgeted contribution margin per composite unit for budgeted mix = × × 28,125(0.16 – 0.20) × $66.40 = $74,700 U

54. 14 - 54 Market-Share Variance Example Actual Market Size × Actual Market Share × Budgeted Average Contribution Margin Per Unit 28,125 × 0.16 × $66.40 = $298,800 Actual Market Size × Budgeted Market Share × Budgeted Average Contribution Margin Per Unit 28,125 × 0.20 × $66.40 = $373,500 $373,500 – $298,800 = $74,700 U

55. 14 - 55 Market-Size Variance Example Market-size variance Actual market size in units – Budgeted market size in units Budgeted market share Budgeted contribution margin per composite unit for budgeted mix = × × (28,125 – 24,500) × 0.20 × $66.40 = $48,140 F

56. 14 - 56 Market-Size Variance Example Actual Market Size × Budgeted Market Share × Budgeted Average Contribution Margin Per Unit 28,125 × 0.20 × $66.40 = $373,500 Static Budget: Budgeted Market Size × Budgeted market share × Budgeted Average Contribution Margin Per Unit 24,500 × 0.20 × $66.40 = $325,360 $373,500 – $325,360 = $48,140 F

57. 14 - 57 Summary of Variances Static-Budget Variance 13,060 U Level 1 Level 2 Flexible-Budget Variance $17,370 F Sales-Volume Variance $30,430 U

58. 14 - 58 Summary of Variances Sales-Volume Variance $30,430 U Level 2 Level 3 Sales-Mix Variance $3,870 U Sales-Quantity Variance $26,560 U

59. 14 - 59 Summary of Variances Sales-Quantity Variance $26,560 U Level 3 Level 4 Market-Share Variance $74,700 U Market-Size Variance $48,140 F

60. 14 - 60 End of Chapter 14