1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 21 C OST A LLOCATION AND P ERFORMANCE M EASUREMENT

2. 21 - 2 A LLOCATING C OSTS FOR P RODUCT C OSTING One of the most difficult tasks in computing accurate unit costs lies in determining the proper amount of overhead cost to assign to each job. Assigning overhead is difficult. I agree!

3. 21 - 3 Jobs Direct Labor Hours Machine Hours Raw Materials Cost Departmental Allocation Bases Stage Two: Costs applied to jobs Stage One: Costs assigned to departments T WO -S TAGE C OST A LLOCATION Service Dept. 2 Service Dept. 3 Service Dept. 1 Operating Dept.1 Operating Dept. 2 Operating Dept. 3 P 1

4. 21 - 4 I LLUSTRATION OF T WO -S TAGE C OST A LLOCATION First, determine the unit cost of each model using traditional costing methods. Ames Company manufactures hammers in regular and deluxe models. Overhead is assigned on the basis of direct labor hours. Budgeted overhead for the current year is $2,000,000. Other information includes: P 1

5. 21 - 5 Overhead Estimated overhead costs Rate Estimated activity = Overhead $2,000,000 Rate 40,000 DLH = = $50 per DLH P 1 I LLUSTRATION OF T WO -S TAGE C OST A LLOCATION

6. 21 - 6 P 1 I LLUSTRATION OF T WO -S TAGE C OST A LLOCATION ABC will result in different overhead cost per unit.

7. 21 - 7 With the Activity-Based Costing (ABC) method, we recognize that many activities within a department drive overhead costs. A BC A C B A CTIVITY -B ASED C OST A LLOCATION Identify activities and assign indirect costs to those activities. Central idea... Products require activities. Activities consume resources. P 2

8. 21 - 8  More detailed measures of costs.  Better understanding of activities.  More accurate product costs for...  Pricing decisions.  Product elimination decisions.  Managing activities that cause costs.  Benefits should always be compared to costs of implementation.  More detailed measures of costs.  Better understanding of activities.  More accurate product costs for...  Pricing decisions.  Product elimination decisions.  Managing activities that cause costs.  Benefits should always be compared to costs of implementation. A CTIVITY -B ASED C OSTING B ENEFITS P 2

9. 21 - 9 A CTIVITY -B ASED C OSTING S TEPS  Identify activities that consume resources.  Assign costs to a cost pool for each activity.  Identify cost drivers associated with each activity.  Compute overhead rate for each cost pool:  Assign costs to products: Overhead Actual Rate Activity × Rate = Estimated overhead costs in activity cost pool Estimated number of activity units P 2

10. 21 - 10 Ames Company plans to adopt activity-based costing. Using the following activity center data, determine the unit cost of the two products using activity-based costing. P 2 I LLUSTRATION OF A CTIVITY -B ASED C OSTING

11. 21 - 11 Total units of activity for both products. P 2 I LLUSTRATION OF A CTIVITY -B ASED C OSTING

12. 21 - 12 Total overhead = $720,000 + $1,280,000 = $2,000,000 Recall that $2,000,000 was the original amount of overhead assigned to the products using traditional overhead costing. P 2 I LLUSTRATION OF A CTIVITY -B ASED C OSTING

13. 21 - 13 P 2 I LLUSTRATION OF A CTIVITY -B ASED C OSTING

14. 21 - 14 This result is not uncommon when activity-based costing is used. Many companies have found that low-volume, specialized products have greater overhead costs than previously realized. C OMPARISON OF T WO -S TAGE AND ABC A LLOCATION P 2

15. 21 - 15 Provide information for managers to use in performance evaluation. Assign costs to managers who are responsible for controlling the costs. Primary goals D EPARTMENTAL A CCOUNTING C 1

16. 21 - 16 Large complex businesses are divided into departments enabling managers to have a smaller effective span of control. M OTIVATION FOR D EPARTMENTALIZATION ProductionSalesService Departments are established for specialized functions. C 1

17. 21 - 17 D EPARTMENTAL E VALUATION The accounting system provides information about resources used and outputs achieved. Managers use this information to control operations, appraise performance, allocate resources, and plan strategy. The type of accounting information provided depends on whether the department is a... Evaluated on ability to control costs. Cost center Evaluated on ability to generate revenues in excess of expenses. Profit center Evaluated on ability to generate return on investment in assets. Investment center C 1

18. 21 - 18 Direct expenses are incurred for the sole benefit of a specific department. Indirect expenses benefit more than one department and are allocated among departments benefited. D EPARTMENTAL E XPENSE A LLOCATION C 1

19. 21 - 19 I LLUSTRATION OF I NDIRECT E XPENSE A LLOCATION Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. C 1

20. 21 - 20 A LLOCATION OF I NDIRECT E XPENSES Indirect expenses can be allocated to departments using a number of allocation bases. Some common indirect expenses and their allocation bases are: C 1

21. 21 - 21 Service department costs are shared, indirect expenses that support the activities of two or more production departments. S ERVICE D EPARTMENT E XPENSES C 1

22. 21 - 22 D EPARTMENTAL I NCOME S TATEMENTS P 3 Let’s prepare departmental income statements using the following steps: 1. Direct expense accumulation. 2. Indirect expense allocation. 3. Service department expense allocation.

23. 21 - 23 Service Dept. One Service Dept. Two Direct expenses are traced to each department without allocation. S TEP 1: D IRECT E XPENSE A CCUMULATION P 3 Operating Dept. One Operating Dept. Two

24. 21 - 24 Indirect expenses are allocated to all departments using appropriate allocation bases. Allocation S TEP 2: I NDIRECT E XPENSE A LLOCATION P 3 Operating Dept. One Operating Dept. Two Service Dept. One Service Dept. Two

25. 21 - 25 Operating Dept. One Operating Dept. Two Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to operating departments. Allocation S TEP 3: S ERVICE D EPARTMENT E XPENSE A LLOCATION P 3 Service Dept. One Service Dept. Two

26. 21 - 26 D EPARTMENTAL E XPENSE A LLOCATION S PREADSHEET Step 1: Direct expenses are traced to service departments and sales departments without allocation. P 3

27. 21 - 27 D EPARTMENTAL E XPENSE A LLOCATION S PREADSHEET Step 2: Indirect expenses are allocated to both the service and the sales departments based on floor space occupied. Of a total of 2,000 square feet, the service departments occupy 200 square feet each, sales department one occupies 600 square feet, and sales department two occupies 1,000 square feet. P 3

28. 21 - 28 Sales department one has $40,000 in sales and sales department two has $48,000 in sales. Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments. D EPARTMENTAL E XPENSE A LLOCATION S PREADSHEET P 3

29. 21 - 29 D EPARTMENTAL E XPENSE A LLOCATION S PREADSHEET Sales department one has 28 employees and sales department two has 40 employees. Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments. P 3

30. 21 - 30 D EPARTMENTAL I NCOME S TATEMENTS P 3

31. 21 - 31 Departmental contribution...  Is used to evaluate departmental performance.  Is not a function of arbitrary allocations of indirect expenses. Departmental revenue – Direct expenses = Departmental contribution D EPARTMENTAL C ONTRIBUTION TO O VERHEAD A department may be a candidate for elimination when its departmental contribution is negative. P 3

32. 21 - 32 D EPARTMENTAL C ONTRIBUTION TO O VERHEAD Net income for the company is still $17,500. Departmental contributions to indirect expenses (overhead) are emphasized. Departmental contributions are positive so neither department is a candidate for elimination. P 3

33. 21 - 33 I NVESTMENT C ENTER R ETURN ON T OTAL A SSETS (ROI) ROI = Investment Center Net Income Investment Center Average Invested Assets LCD Division earned more dollars of income, but it was less efficient in using its assets to generate income compared to S-Phone Division. A 1

34. 21 - 34 Residual Income Investment Center Net Income Target Investment Center Net Income =– I NVESTMENT C ENTER R ESIDUAL I NCOME The target net income is 8% of divisional assets. A 1

35. 21 - 35 Innovation and Learning How can we continually improve and create value? Internal Business Processes In which activities must we excel? B ALANCED S CORECARD Performance Measures Financial Perspective How do we look to the firm’s owners? Customer Perspective How do our customers see us? A 1

36. 21 - 36 C ONTROLLABLE VERSUS D IRECT C OSTS Costs are controllable if the manager has the power to determine, or strongly influence, the amounts incurred. A manager’s performance evaluation should be based on controllable costs. Direct costs are traced to departments, but may not be controllable by the department manager. Example: Department managers usually have no control over their own salaries. C 2

37. 21 - 37 An accounting system that provides information... R ESPONSIBILITY A CCOUNTING S YSTEM Relating to the responsibilities of individual managers. To evaluate managers on controllable items. C 2

38. 21 - 38 Responsibility Accounting Successful implementation of responsibility accounting may use organization charts with clear lines of authority and clearly defined levels of responsibility. C 2

39. 21 - 39 Amount of detail varies according to the level in the organization. A department manager receives detailed reports. A store manager receives summarized information from each department. R ESPONSIBILITY A CCOUNTING P ERFORMANCE R EPORTS C 2

40. 21 - 40 To be of maximum benefit, responsibility reports should...  Be timely.  Be issued regularly.  Be understandable.  Compare budgeted and actual amounts. R ESPONSIBILITY A CCOUNTING P ERFORMANCE R EPORTS C 2

41. 21 - 41 G LOBAL V IEW L’Oreal is an international cosmetics company incorporated in France. With multiple brands and operations in over 100 countries, the company uses concepts of departmental accounting and controllable costs to evaluate performance. A recent annual report shows the following for the major divisions in L’Oreal’s Cosmetics branch: L’Oreal’s non-allocated costs include costs that are not controllable by division managers. Excluding noncontrollable costs enables L’Oreal to prepare more meaningful division performance evaluations.

42. 21 - 42 I NVESTMENT C ENTER P ROFIT M ARGIN AND I NVESTMENT T URNOVER A 2 Return on investment (ROI) = Profit Margin Investment turnover × Investment center sales Investment center average assets Investment center net income Investment center sales Domestic ROI = 16.64% International ROI = 2.56%

43. 21 - 43 A transfer price is the amount charged when one division sells goods or services to another division. LCD Displays LCD DivisionS-Phone Division A PPENDIX 21A: T RANSFER P RICING S-Phone can purchase displays for $80 from other companies. C 3

44. 21 - 44 A PPENDIX 21A: T RANSFER P RICING LCD is producing and selling 100,000 units to outside customers. (No excess capacity) Transfer price = $80. With no excess capacity, the LCD manager will not accept a transfer price less than $80 per monitor. The S-Phone manager cannot buy monitors for less than $80 from outside suppliers, so the $80 price is acceptable. LCD Displays LCD DivisionS-Phone Division C 3

45. 21 - 45 A PPENDIX 21A: T RANSFER P RICING Transfer price = $40 to $80. LCD Displays LCD DivisionS-Phone Division LCD is producing and selling less than100,000 units to outside customers. (Excess capacity) At a transfer price greater than $40, the LCD division receives contribution margin. At a transfer price less than $80, the S-Phone manager is pleased to buy from LCD, since that price is below the market price of $80. C 3

46. 21 - 46 A PPENDIX 21B: J OINT COSTS AND T HEIR A LLOCATION Joint costs are costs incurred to produce or purchase two or more products at the same time. Consider a sawmill company: How should the joint costs be allocated to the different products? C 4

47. 21 - 47 A PPENDIX 21B: J OINT COSTS AND T HEIR A LLOCATION Physical Basis Allocation of Joint Cost 10,000 ÷ 100,000 = 10%10% of $30,000 = $3,000 C 4

48. 21 - 48 A PPENDIX 21B: J OINT COSTS AND T HEIR A LLOCATION Value Basis Allocation of Joint Cost $12,000 ÷ $50,000 = 24%24% of $30,000 = $7,200 C 4

49. 21 - 49 E ND OF C HAPTER 21