4. MY HOUSE – HOUSE # 1 HOUSE # 2 YOUR HOUSE –HOUSE # 3

5. HOUSE COSTS HOUSE #1 HOUSE #2 HOUSE #3 Direct Material$140,000 $70,000 $90,000 Direct Labor 210,000 130,000 60,000 Overhead*? ? ? *Total indirect costs such as supervisory salaries and indirect materials amount to $84,000

6. Cost Object The builder wants to determine the cost for each house The house is the COST OBJECT

7. HOUSE COSTS HOUSE #1 HOUSE #2 HOUSE #3 Overhead* 28,000 28,000 28,000 *Total indirect costs such as supervisory salaries and indirect materials amount to $84,000 There are three houses & each should have the same amount of overhead. Do you agree?

8. Use of Cost Drivers to Accumulate Costs Machine hours Miles driven Labor hours Units produced A cost driver is any factor that causes or “drives” an activity’s costs

9. How should the costs be allocated? House 1House 2House 3 Ttl Direct Costs 350,000 200,000 150,000 Total Direct Costs for All Houses = $700,000 What cost needs to be allocated? $84,000 1 st – Find Allocation Rate = $84,000 / $700,000 = 0.12 COST DRIVER

10. Overhead Cost Allocation House 1 : $0.12 * 350,000 = 42,000 House 2 : $0.12 * 200,000 = 24,000 House 3 : $0.12 * 150,000 = 18,000

11. HOUSE #1 HOUSE #2 HOUSE #3 Direct Material$140,000 $70,000 $90,000 Direct Labor 210,000 130,000 60,000 Overhead*? ? ? *Total indirect costs such as supervisory salaries and indirect materials amount to $84,000 Assume the $84,000 of total overhead cost consists of $63,000 of indirect materials and $21,000 of employee benefits.

12. Let’s start w/ $63,000 of Indirect Materials What should we use to allocate the indirect materials? Direct Material Total Direct Materials = $300,000 Amount to Allocate = $63,000 Allocation Base = $300,000 House 1: (63,000 / 300,000) * 140,000 = 29,400 COST DRIVER ALLOCATION RATE

13. What about the $21,000 Employee Benefits? What is the cost driver? Direct Labor What is the allocation base? $400,000 What amount needs to be allocated? $21,000 What is the allocation rate? $21,000 / $400,000 = 0.0525

14. Allocation of Benefits House 1: 0.0525 * 210,000 = 11,025 House 2: 0.0525 * 130,000 = 6,825 House 3: 0.0525 * 60,000 = 3,150

15. The Builder also incurred the following expenses: Electric - $4,000 Gas - $2,000 Water - $1,000 Telephone - $500 Is it cost effective to allocate each of these expenses individually? –NO!

16. COST POOL Cost Pool Total = $7,500 Cost Pool = Utilities WATER $1,000 ELECTRICITY $4,000 GAS $2000 TELEPHONE $500

17. Cost Pool Allocation What should be use to allocate the utilities? What about square footage? House 1 = 5,000 sq ft House 2 = 3,000 sq ft House 3 = 1,000 sq ft Total Square Footage = 9,000 COST DRIVER ALLOCATION BASE

18. Allocation of Utilities Allocation Rate: $7,500 / 9,000 = $0.833 House 1: $0.833 * 5,000 = 4,167 House 2: $0.833 * 3,000 = 2,500 House 3: $0.833 * 1,000 = 833

19. Estimated Versus Actual Cost Estimated Costs Managers use estimated costs to make decisions about the future. Actual Costs Knowledge of actual costs, after the fact, may not be useful for planning and decision making.

20. Estimated Versus Actual Cost Potential Inaccuracies TimelyRelevant Estimated Costs Managers use estimated costs to make decisions about the future.

21. Estimated Versus Actual Cost Estimated Costs May be used to set prices, make bids, evaluate proposals, distribute resources, plan production, and set goals. Potential Inaccuracies TimelyRelevant

22. In Style, Inc. Department Store pays a bonus to each department manager based on departmental sales. The incentive has increased departmental sales, but departmental profits have not increased accordingly. Management has decided to base future bonuses on department profitability. In Style, Inc. Department Store pays a bonus to each department manager based on departmental sales. The incentive has increased departmental sales, but departmental profits have not increased accordingly. Management has decided to base future bonuses on department profitability. Identifying Direct Versus Indirect Costs

23. The first step in the development of the new bonus strategy is to determine the costs of each department. Costs that can be traced to departments in a cost-effective manner are called direct costs. Costs that cannot be traced to departments in a cost-effective manner are called indirect costs. The first step in the development of the new bonus strategy is to determine the costs of each department. Costs that can be traced to departments in a cost-effective manner are called direct costs. Costs that cannot be traced to departments in a cost-effective manner are called indirect costs. Identifying Direct Versus Indirect Costs

25. Direct and indirect costs may be either fixed or variable. A cost can be either direct or indirect depending on the cost object. The store manager salary is indirect to any one department, but is directly traceable to the store. Identifying Direct Versus Indirect Costs

26. Allocating Indirect Costs to Departments Identify the most appropriate cost driver for each indirect cost. Indirect costs should be allocated to reflect how the departments consume resources. In Style, Inc. chose these cost drivers:

27. Allocating Indirect Costs to Departments Use a two-step process to allocate indirect costs:  Allocation rate = total cost ÷ cost driver activity.  Allocated cost = allocation rate × weight of the cost driver activity.

28.  $9,360 ÷ 3 departments = $3,120 per department  $3,120 × 1 department = $3,120 Allocating Indirect Costs to Departments

29.  $18,400 ÷ 23,000 square feet = $0.80 per square foot  $0.80 × 12,000 Women’s square feet = $9,600 $0.80 × 7,000 Men’s square feet = $5,600 $0.80 × 4,000 Children’s square feet = $3,200 Allocating Indirect Costs to Departments

30.  $2,300 ÷ 23,000 square feet = $0.10 per square foot  $0.10 × 12,000 Women’s square feet = $1,200 $0.10 × 7,000 Men’s square feet = $700 $0.10 × 4,000 Children’s square feet = $400 Allocating Indirect Costs to Departments

31.  $7,200 ÷ $360,000 sales = $0.02 per sales dollar  $0.02 × $190,000 Women’s sales = $3,800 $0.02 × $110,000 Men’s sales = $2,200 $0.02 × $60,000 Children’s sales = $1,200 Allocating Indirect Costs to Departments

32.  $900 ÷ $360,000 sales = $0.0025 per sales dollar  $0.0025 × $190,000 Women’s sales = $475 $0.0025 × $110,000 Men’s sales = $275 $0.0025 × $60,000 Children’s sales = $150 Allocating Indirect Costs to Departments

33. Now let’s combine the costs and revenues and see how departmental profitability looks. Allocating Indirect Costs to Departments

35. The Effects of Cost Behavior on Cost Driver Selection Does this mean that I should use different cost drivers for variable and fixed overhead?

36. Using Volume Measures to Allocate Variable Overhead Costs Increases in the volume of production will cause variable overhead costs to increase. Volume measures serve as good cost drivers for the allocation of variable overhead. Units Produced Labor Hours Materials Used

37. Filmier Furniture Company Production and Cost Information Use the two-step process to allocate indirect materials cost using the three volume measures as cost drivers. Using Volume Measures to Allocate Variable Overhead Costs

38.  $60,000 ÷ 5,000 units = $12 per unit  $12 per unit × 4,000 chairs = $48,000 $12 per unit × 1,000 desks = $12,000 Using Volume Measures to Allocate Variable Overhead Costs

39.  $60,000 ÷ 6,000 hours = $10 per hour  $10 per hour × 3,500 hours = $35,000 $10 per hour × 2,500 hours = $25,000 Using Volume Measures to Allocate Variable Overhead Costs

40.  $60,000 ÷ $1,500,000 of direct material = $0.04 per dollar of direct material  $0.04 per $ × $1,000,000 = $40,000 $0.04 per $ × $500,000 = $20,000 Using Volume Measures to Allocate Variable Overhead Costs

41. Selecting the Best Cost Driver So which volume measure should I use? Judgment and reasoning are necessary. Considerations Relationship between cost driver activity and use of resources. Availability of information. Judgment and reasoning are necessary. Considerations Relationship between cost driver activity and use of resources. Availability of information.

42. Allocating Fixed Overhead Costs Objective Distribute a fair share of the overhead cost to each product. There are no volume based cost drivers for fixed overhead.

43. Allocating Fixed Overhead Costs Belview Company Information Use the two-step process to allocate the fixed rental cost to units sold and to units in ending inventory.

44. Allocating Fixed Overhead Costs  $28,000 ÷ 2,000,000 units = $0.014 per unit  $0.014 per unit × 1,800,000 units = $25,200 $0.014 per unit × 200,000 units = $2,800

45. Allocating Costs to Solve Timing Problems Allocating fixed costs can be complicated when the volume of production varies from month to month. If prices are based on these costs, units produced in January will be higher than those produced in February. Will customers think this is reasonable?

46. Allocating Costs to Solve Timing Problems We solve this problem by using estimated costs and estimated production for the year to obtain a predetermined overhead rate (POHR). Estimated overhead the year Estimated allocation base for the year POHR = $36,000 18,000 units POHR = = $2.00 per unit $2.00 allocated to each unit produced for all months during the year.

47. Establishing Cost Pools Indirect Cost 1 Indirect Cost 3 Indirect Cost 2 Indirect Cost 4 Indirect Cost 5 Product 3 Product 1 Product 2 This is the problem when we don’t use cost pools to allocate costs. 15 allocations

48. Establishing Cost Pools Indirect Cost 1 Indirect Cost 3 Indirect Cost 2 Indirect Cost 4 Indirect Cost 5 Cost Pool Product 3 Product 1 Product 2 Three allocations Cost pools reduce the number of cost allocation computations. Contains indirect costs related to a common cost driver.

49. Allocating Joint Costs Joint Costs Product

50. Key terms Joint products – products resulting from a process with a common input. Split-off point – the stage of processing where joint products are separated. Joint cost – costs of processing joint products prior to the split-off point. Key terms Joint products – products resulting from a process with a common input. Split-off point – the stage of processing where joint products are separated. Joint cost – costs of processing joint products prior to the split-off point. Allocating Joint Costs

51. Consider the following example of an oil refinery. We will assume only two products, gasoline and oil. Allocating Joint Costs

52. Joint Input Common Production Process Final Sale Final Sale Split-Off Point Joint Costs OilGasoline Separate Processing Separate Processing Costs Separate Processing Separate Processing Costs Allocating Joint Costs

53. Joint Cost Allocation Methods Physical quantities method Relative Sales Value Method Joint costs are allocated based on a relative measure (weight, volume, etc.) of the products at the split-off point. Joint costs are allocated based on the relative values of the products at the split-off point.

54. Let’s look at an example illustrating the joint cost allocation methods. Joint Cost Allocation Methods

55. Common Production Process Split-Off Point OilGasoline Physical Quantities Method 240,000 gallons 360,000 gallons Joint material cost = $275,000 Joint conversion cost = $225,000

56. Physical Quantities Method

58. $225,000 joint conversion cost plus $275,000 joint material cost

59. Joint material cost = $275,000 Common Production Process Split-Off Point Joint conversion cost = $225,000 OilGasoline Relative Sales Value Method $200,000 sales value at split-off point $600,000 sales value at split-off point

60. Relative Sales Value Method

62. $225,000 joint conversion cost plus $275,000 joint material cost Relative Sales Value Method

63. By-Products Joint Input Joint Production Process Split-Off Point Joint Costs By-products Relatively low value relative to major products. Major Product

64. Joint Costs and the Issue of Relevance The allocated portion of a joint cost is not relevant to a decision regarding further processing. A product should be processed beyond the split-off point only if if the incremental revenue exceeds the incremental processing costs. The allocated portion of a joint cost is not relevant to a decision regarding further processing. A product should be processed beyond the split-off point only if if the incremental revenue exceeds the incremental processing costs.

65. Cost Allocation: The Human Factor Is it fair to divide the College of Business copy budget equally? I think we consider the number of faculty. I think we consider the number of students.

66. Cost Allocation: The Human Factor Let’s see how the allocation of budgeted amounts will effect the different departments. We will begin by allocating equal amounts.

67. Cost Allocation: The Human Factor Who is happy? Who is unhappy?

68. Cost Allocation: The Human Factor Now let’s allocate the $36,000 budget based on the number of faculty in each department.

69. Cost Allocation: The Human Factor Who is happy? Who is unhappy?  $36,000 ÷ 72 faculty = $500 per faculty member  $500 × 29 faculty members = $14,500 $500 × 16 faculty members = $8,000 $500 × 12 faculty members = $6,000 $500 × 15 faculty members = $7,500

70. Cost Allocation: The Human Factor Now let’s allocate the $36,000 budget based on the number of students in each department.

71. Cost Allocation: The Human Factor Who is happy? Who is unhappy?  $36,000 ÷ 1,200 students = $30 per student  $30 per student × 330 students = $9,900 $30 per student × 360 students = $10,800 $30 per student × 290 students = $8,700 $30 per student × 220 students = $6,600

72. End of Chapter Five