2. 7-1 Designing Product Cost Systems C hapter 7 Prepared by Douglas Cloud Pepperdine University

3. 7-2 1.Define and explain the primary elements of an indirect cost allocation system. 2.Describe the process of allocating service department costs, including the treatment of interdepartmental services. 3.Compare and contrast activity-based costing (ABC) and traditional organizational-based costing (OBC). ObjectivesObjectives After studying this chapter, you should be able to: ContinuedContinued

4. 7-3 4.Calculate overhead rates under three methods on the product costing continuum using a plantwide rate, departmental rates, or activity- based rates. 5.Discuss the issue associated with implementing an activity-based costing system. 6.Explain the uses and evolution of ABC. ObjectivesObjectives

5. 7-4 Controlling Indirect Costs The purpose of this chapter is to explore the nature of indirect costs and frequently used approaches to reassigning indirect costs to products or services.

6. 7-5 Allocating Indirect Costs Costs incurred for the common benefit of all occupants of a building is an indirect, or common cost. A cost objective is anything to which costs are assigned, e.g., the cost of inspecting incoming raw materials. A cost pool is a collection of related costs that is assigned to one or more cost objectives.

7. 7-6 Cost Allocation Base Indirect Cost Category Allocation Base Employee health servicesNumber of employees or visits PersonnelNumber of employees or new hires Maintenance and repairs Number of repair orders or service hours PurchasingNumber of orders placed Warehouse Square footage used or value of materials stored

8. 7-7 Production and Service Department Costs Departments which provide support services to production and/or other support departments are called service departments.

9. 7-8 Production and Service Department Costs A direct department cost is a cost assigned directly to a department (production service) when it is incurred.

10. 7-9 Production and Service Department Costs An indirect department cost is a cost assigned directly to a department as a result of an indirect allocation, or reassignment from another department or cost object.

11. 7-10 Direct Method Flow of Costs Support Services Building and Grounds Service Departments Engineering Resources Product Product Product MixingBottling Producing Departments

12. 7-11 Support Services Mixing Bottling Departmental cost before allocations $27,000$40,000$ 90,000 Support Services-27,000 Allocation based on invested capital Direct Method

13. 7-12 Support Services Mixing Bottling Departmental cost before allocations Support Services-27,00010,800 $180,000/$450,000 x $27,000 Direct Method $27,000$40,000$ 90,000

14. 7-13 Support Services Mixing Bottling Departmental cost before allocations Support Services27,00010,80016,200 $270,000/$450,000 x $27,000 Direct Method $27,000$40,000$ 90,000

15. 7-14 Engineering Resources Mixing Bottling Departmental cost before allocations $20,000$40,000$ 90,000 Support Services10,80016,200 Direct Method

16. 7-15 Engineering Resources Mixing Bottling Departmental cost before allocations $20,000$40,000$ 90,000 Support Services10,80016,200 Engineering Resources-20,000 Allocation based on number of employees Direct Method

17. 7-16 Engineering Resources Mixing Bottling Departmental cost before allocations $20,000$40,000$ 90,000 Support Services10,80016,200 Engineering Resources-20,0006,000 24/80 x $20,000 Direct Method

18. 7-17 Engineering Resources Mixing Bottling Departmental cost before allocations $20,000$40,000$ 90,000 Support Services10,80016,200 Engineering Resources-20,0006,00014,000 56/80 x $20,000 Direct Method

19. 7-18 Building and Grounds Mixing Bottling Departmental cost before allocations $10,000$40,000$ 90,000 Support Services10,80016,200 Engineering- Resources6,00014,000 Building and Grounds-10,000 Direct Method Allocation based on squared footage occupied

20. 7-19 Building and Grounds Mixing Bottling Departmental cost before allocations $10,000$40,000$ 90,000 Support Services10,80016,200 Engineering Resources6,00014,000 Building and Grounds-10,0002,500 Direct Method 25% x $10,000

21. 7-20 Building and Grounds Mixing Bottling Departmental cost before allocations $10,000$40,000$ 90,000 Support Services10,80016,200 Engineering Resources6,00014,000 Building and Grounds-10,0002,5007,500 Direct Method 75% x $10,000

22. 7-21 Building and Grounds Mixing Bottling Departmental cost before allocations $10,000$40,000$ 90,000 Support Services10,80016,200 Engineering Resources6,00014,000 Building and Grounds -10,000 2,500 7,500 Departmental costs after allocation$ 0 $59,300$127,700 Direct Method

23. 7-22 The step method gives partial recognition of interdepartment services. Step Method

24. 7-23 Engineering Resources Building and Grounds Service Departments Support Resources Product Product Product MixingBottling Producing Departments Step Method

25. 7-24 Engineering Support Building & Resources Services Grounds Mixing Bottling $20,000$27,000$ 10,000$40,000$ 90,000 First, let’s examine the departmental costs before allocation. Step Method

26. 7-25 $20,000$27,000$ 10,000$40,000$ 90,000 Engineering Support Building & Resources Services Grounds Mixing Bottling The Engineering Resources Department’s cost is allocated on the basis of number of employees. Step Method

27. 7-26 Engineering Support Building & Resources Services Grounds Mixing Bottling $20,000$27,000$ 10,000$40,000$ 90,000 (20,000)3,0001,0004,80011,200 5/100 x $20,000 24/100 x $20,000 56/100 x $20,00015/100 x $20,000 Step Method

28. 7-27 Engineering Support Building & Resources Services Grounds Mixing Bottling $20,000$27,000$ 10,000$40,000$ 90,000 (20,000)3,0001,0004,80011,200 Next, the Support Service Department is allocated based on capital investment. Step Method

29. 7-28 Engineering Support Building & Resources Services Grounds Mixing Bottling $20,000$27,000$ 10,000$40,000$ 90,000 (20,000)3,0001,0004,80011,200 (30,0003,00010,80016,200 ) $50,000/$500,000 x $30,000$180,000/$500,000 x $30,000 $270,000/$500,000 x $30,000 Step Method

30. 7-29 Step Method Engineering Support Building & Resources Services Grounds Mixing Bottling $20,000$27,000$ 10,000$40,000$ 90,000 (20,000)3,0001,0004,80011,200 (30,0003,00010,80016,200 ) Finally, the Building and Grounds Department is allocated to the production departments on the bases of square footage.

31. 7-30 Engineering Support Building & Resources Services Grounds Mixing Bottling $20,000$27,000$ 10,000$40,000$ 90,000 (20,000)3,0001,0004,80011,200 (30,0003,00010,80016,200 (14,0003,50010,500 ) ) 11,000/44,000 x $14,000 33,000/44,000 x $14,000 Step Method

32. 7-31 Engineering Support Building & Resources Services Grounds Mixing Bottling $20,000$27,000$ 10,000$40,000$ 90,000 (20,000)3,0001,0004,80011,200 (30,0003,00010,80016,200 (14,0003,50010,500 $ 0$ 0$59,100$127,900 ) ) $ 0 Step Method

33. 7-32 Linear Algebra Method The linear algebra method uses a series of linear algebraic equations, which are solved simultaneously, to allocate service cost interdepartmentally and to the producing departments.

34. 7-33 Product Product Product Producing Departments Flow of Costs Service Departments S1S2 P1P2 Linear Algebra Method

35. 7-34 Activity-Based and Organization-Based Costing Traditional costing considers the cost of a product to be its direct costs for materials and...

36. 7-35 … labor, plus some allocated portion of factory overhead. Activity-Based and Organization-Based Costing

37. 7-36 Activity-Based and Organization-Based Costing In OBC, overhead rates are allocated to products using a plant-wide or departmental overhead rates. In brief, cost assignment follows the organization chart.

38. 7-37 Activity-Based and Organization-Based Costing ABC costing is based on the notion that companies incur costs because of the activities they conduct in pursuit of their goals and objectives.

39. 7-38 Activity-Based and Organization-Based Costing In many OBC systems, overhead is assigned no one or more cost pools, and then reassigned to products using a general allocation base.

40. 7-39 ABC Two-Stage Costing Model Continued on next slide Department 1 Direct product costs Department 2 Direct product costs Department N Direct product costs Department 1 Indirect costs Department 2 Indirect costs Department N Indirect cost $$$$$$ Resource Costs to Cost of Product Activity Cost Pools

41. 7-40 $$$$$$ Second stage: Costs assigned to activities are reassigned to cost objectives using an activity cost driver. Department 1 Indirect costs Department 2 Indirect costs Department N Indirect cost Cost of products

42. 7-41 Using OBC Allocation 1.Maintenance department costs would typically be allocated to production departments based on the number of repair orders or the number of service hours associated with repairs done in each production department. 2.Purchasing department costs may be allocated to production departments based on the dollar value of raw materials issued to each department. 3.In a pure OBC system, department costs are allocated first to the producing departments using the direct, step, or linear algebra method.

43. 7-42 Conclusions of Activity- Based Costing ABC normally uses a greater of costs pools than OBC allocation methods. ABC does not use the established departmental structure for pooling costs unless that structure happens to coincide with key activities. ABC is more insistent on the use of causal factors than OBC. ContinuedContinued

44. 7-43 ABC assigns costs based on their activity cost drivers, and if cost drivers cannot be identified and measured, ABC cannot be used to assign those costs. Implementation of ABC requires an understanding of the production process, the activities that occur in the production process, and the cost drivers that generate the costs of those activities. Implementation and operation of ABC is more likely to involve the use of judgment than the operation of an OBC system.

45. 7-44 Product Costing Continuum Organization-Based Costing (OBC) Activity-Based Costing (ABC) Plant-Wide Overhead Departmental Overhead Rate Methods Two-Stage Models Multiple Stage Models SimpleComplex ImprecisePrecise

46. 7-45 The Product Costing Continuum Illustrated Krown Drink produced 232 barrels of Carbonated drink and 400 barrels of Fruit drink. Estimated manufacturing overhead is $187,000 and estimated machine hours total 1,496.

47. 7-46 Overhead rate = $187,000 1,496 Overhead rate = $125 per m/h The Product Costing Continuum Illustrated

48. 7-47 Direct materials$125$120 Direct labor11030 Manufacturing overhead: Carbonated (3 x $125) 375 Fruit (2 x $125) 250 Total unit cost$610$400 Unit Costs Carbonated Fruit The Product Costing Continuum Illustrated

49. 7-48 Applying Overhead with Departmental Rates Total Departmental Manufacturing Overhead$59,100$127,900 Quantity of Base: Direct Labor Hours  500 Machine Hour  800 Overhead Rates$118.20$159.875 Mixing Bottling

50. 7-49 Direct materials$125$120 Direct labor11030 Manufacturing overhead: Mixing (l/h x $118.20)11879 Bottling (m/h x $159.875) 160 227 Total costs$513$456 Unit Costs Carbonated Fruit Applying Overhead with Departmental Rates

51. 7-50 Overhead Activity and Cost Direct departmental overhead costs: Mixing$40,000/500 = $80 per labor hour Bottling$90,000/800 = $112.50 per m/h Common overhead costs: Support Services: Receiving $14,000/100 = $140 per order Inventory Control $13,000/632 = $20.57 per unit Unit Activity Rates Continued Applying Overhead with Departmental Rates

52. 7-51 Overhead Activity and Cost Engineering Resources: Production Setup $12,000/20 = $600 per run Engineering and Testing $8,000/800 = $10 per m/h Building and Grounds: Maintenance, machines $4,000/800 = $5 per m/h Depreciation, machines $6,000/632 = $9.49 per unit Unit Activity Rates Applying Overhead with Departmental Rates

53. 7-52 Carbonated Mixing ($80 x 232 labor hours)$18,560 Bottling ($112.50 x 174 machine hours)19,575 Receiving ($140 x 40 orders)5,600 Inventory control ($20.57 x 232 units)4,772 Production setup ($600 x 5 runs)3,000 Engineering and Testing ($10 x 174 m/h)1,740 Maintenance, machines ($5 x 174 units)870 Depreciation, machines ($9.49 x 232 units) 2,202 Total factory overhead product cost$56,319 Factory overhead cost per unit ($56,319/232) $243 Applying Overhead with Departmental Rates

54. 7-53 Fruit Mixing ($80 x 268 labor hours)$ 21,440 Bottling ($112.50 x 626 machine hours)70,425 Receiving ($140 x 60 orders)8,400 Inventory control ($20.57 x 400 units)8,228 Production setup ($600 x 15 runs)9,000 Engineering and Testing ($10 x 626 m/h)6,260 Maintenance, machines ($5 x 626 units)3,130 Depreciation, machines ($9.49 x 400 units) 3,796 Total factory overhead product cost$130,679 Factory overhead cost per unit ($130,679/400) $327 Applying Overhead with Departmental Rates

55. 7-54 Direct materials$125$120 Direct labor11030 Manufacturing overhead243327 Total costs using ABC$478$477 Unit Costs Carbonated Fruit Applying Overhead with Departmental Rates

56. 7-55 Practical Advice for Implementing ABC 1.Capture the attention of top management. 2.Don’t shoot the customer. 3.Decide the form ABC will take. 4.Supplement the ABC measures creativity where appropriate. 5.Be careful in costing bottlenecks that create excess capacity. 6.Challenge managers who believe their costs are fixed. 7.Calculate costs top-down and bottom-up. 8.Account for cost of capital. 9.Use multi-functional teams. 10.Don’t underestimate the need for managing change.

57. 7-56C hapter 7 The End

58. 7-57