1. 1

2. 2 We Allocate Costs for Many Reasons LO1: Understand how to use cost allocations to make long-term decisions

3. 3 What is an Allocation? (Review) To distribute a common cost or benefit among different items  Dinner bill among friends  Rent among roommates  Overhead costs among products  Salesperson salary among customers  Sales revenue among bundled products Mechanics [Split $80 among two families (2 and 3 people)]  Cost Pool  Allocation basis  Denominator volume  Cost object LO1: Understand how to use cost allocations to make long-term decisions

4. 4 Steps in Every Allocation Divide cost in pool by denominator volume to get allocation rate  $80 / 5 persons = $16 per person Multiply rate by the number of driver units in cost object to determine allocated cost  3 persons * $16/person = $48  2 persons * $16/person = $32 Properties of allocations  Driver units must be traceable at the level of the cost object  % cost allocated = % driver units  60% of cost to family 1  3 of 5 persons from family 1 LO1: Understand how to use cost allocations to make long-term decisions

5. 5 Allocations for Decision Making Use to estimate change in controllable capacity costs Let us consider an example  EZ rest is currently making 18,000 standard and 12,000 deluxe mattresses.  What is the expected profit if EZ-Rest changes its product mix to make 10,000 standard and 20,000 deluxe mattresses? LO1: Understand how to use cost allocations to make long-term decisions

6. 6 EZ Rest Company: Basic Data

7. 7 What is Profit with New Mix? Suppose we wish to change the product mix to 10,000 Standard and 20,000 deluxe mattresses. What is the profit with the new mix? One estimate is as below: LO1: Understand how to use cost allocations to make long-term decisions

8. 8 $1,350,000 $1,800,000 42.86%57.14% $3,240,000 $4,320,000 42.86% 57.14%

9. 9 Should We Change the Mix? This estimate is probably wrong!  Dealing with long-term decisions  Capacity cost is controllable over this decision horizon  Profit margin is correct measure to use But, capacity cost is:  Common across many products  Lumpy How to estimate the change in capacity costs? LO1: Understand how to use cost allocations to make long-term decisions

10. 10 Estimating Change in Capacity Cost Need model of how costs will change  Can do direct estimation  Can employ allocations to approximate change  Similar to use of High-Low method in short-term decisions Allocated cost is estimate of  Change in capacity cost due to change in  Product volume and/or product mix  Customer volume and / or mix  Activity volume …… LO1: Understand how to use cost allocations to make long-term decisions

11. 11 Example (Revisited) Experts estimate (using account analysis) is that capacity costs would increase by $890,000.  Good idea for large decisions / new endeavors  Tedious and difficult to do How do allocations help?  Cost pool is overhead cost of $7.56 MM  Suppose we allocate based on labor $  Labor cost is the allocation basis or cost driver  Denominator volume = $3,150,000  (18,000 standard x $75 / standard mattress) + (12,000 deluxe x $150/deluxe mattress)  Rate = $7,560,000/$3,150,000 = $2.40 per labor $ LO1: Understand how to use cost allocations to make long-term decisions

12. 12 Estimated Capacity Cost New Mix: 10,000 standard, & 20,000 deluxe Estimated labor cost with new mix  $3, 750,000 = 10,000 std x $75/unit + 20,000 deluxe x $150/unit Estimated overhead cost  $3,750,000 x $2.40 / labor $ = $9,000,000 Changing product mix increases capacity cost by $1.44 MM from $7.56 million to $9 million. LO1: Understand how to use cost allocations to make long-term decisions

13. 13 Revised Profit Estimate Changing the mix is not a good idea! LO1: Understand how to use cost allocations to make long-term decisions

14. 14 How We Allocate Matters Suppose we used units (i.e., a mattress) as the basis for allocation (and not labor hours) Rate = $7,560,000 / (18,000+12,000) units = $252/unit New mix:  10,000 units of standard,  20,000 units of deluxe New estimated overhead cost $7,560,000 = 10,000 std x $252/unit + 20,000 deluxe x $252/unit Why no change in profit?  Allocation basis does not distinguish among kinds of mattresses  Total number of mattresses has not changed. Thus, estimate based on allocation too does not change LO1: Understand how to use cost allocations to make long-term decisions

15. 15 $7,560,000 / 30,000 1 1 $252 1 1 $2,520,000$5,040,000

16. 16 Explanation for Check It! Exercise #2 The total does not change because we have 30,000 units both under the current and projected mix. Furthermore, when we choose units as the allocation basis, the fixed overhead estimate is proportional to total units. This estimate is likely to be erroneous because manufacturing capacity costs are not likely to be related to units sold— that is, Standard and Deluxe mattresses consume varying amounts of resources. As discussed in the text, the Deluxe mattresses use much more labor time, which, in turn, leads to greater use of the factory’s capacity.

17. 17 Improving Estimate We can account for the makeup of the capacity cost  We can use more cost pools to account for different kinds of capacity cost  $7,560,000 = $5,040,000 (mfg) + $2,520,000 (SG&A)  Not reasonable to assume both pieces vary with labor $  Units may be better for SG&A We can use different drivers for different pools to improve our prediction  Manufacturing (allocate with labor $)  SG&A (allocate with units) LO1: Understand how to use cost allocations to make long-term decisions

18. 18 Total fixed costs $7,560,000 Total fixed costs $7,560,000 Marketing cost pool $2,520,000 Marketing cost pool $2,520,000 Manufacturing cost pool $5,040,000 Manufacturing cost pool $5,040,000 Total fixed costs $7,560,000 Total fixed costs $7,560,000 Standard $3,240,000 Standard $3,240,000 Deluxe $4,320,000 Deluxe $4,320,000 Standard $2,160,000 + $1,512,000 = $3,672,000 Standard $2,160,000 + $1,512,000 = $3,672,000 Deluxe $2,880,000 + $1,008,000 = $3,888,000 Deluxe $2,880,000 + $1,008,000 = $3,888,000 Panel A Panel B LO1: Understand how to use cost allocations to make long-term decisions Direct Labor cost ($2.40 / DL$) Labor cost ($1.60/DL$) Units ($84/unit)

19. 19 Estimated Profit (Two Pool System) LO1: Understand how to use cost allocations to make long-term decisions

20. 20 Example (wrap up) Overhead rates  Manufacturing - $1.60/labor $  Marketing - $84.00/unit Revised capacity cost  Manufacturing $3.75 MM x $1.60/labor$ = $6.00 MM  Marketing 30 K units x $84 /unit = $2.52 MM  Total = $8.52 MM Revised profit = $100,000 We can refine with more pools if needed  As we increase number of pools, the allocation begins to resemble direct estimation LO1: Understand how to use cost allocations to make long-term decisions

21. 21 ALLOCATIONS FOR VALUING INVENTORY

22. 22 Why do We Need This Allocation? Required by GAAP  Determine inventory values Matching principle  Manufacturing costs inventoriable  Pertains to units made  Product cost / Inventoriable cost  SGA cost is expensed  Pertains to units sold  Period cost LO2: Explain how cost allocations affect income.

23. 23 1 1 2 2 $4,352,000 / 17,000 1 1 $3,514,800 / 11,600 2 2 Thus, the contribution lost because of the lower sales volume (relative to the volume in Exhibit 9.1) is: (1,000 Standard x $256) + (400 Deluxe x $303 per mattress) = $377,200. 3 3 $256 $303 3 3 $7,560,000

24. 24 In Income StatementIn Balance Sheet Produce units Standard: 18,000 units Deluxe: 12,000 units Produce units Standard: 18,000 units Deluxe: 12,000 units Panel A: Physical flow of units Spend $5,040,000 on fixed manufacturing overhead Panel B: Variable Costing Expense the entire amount $5,040,000 Sell units Standard: 17,000 units Deluxe: 11,600 units Sell units Standard: 17,000 units Deluxe: 11,600 units Put units into inventory Standard: 1,000 units Deluxe: 400 units Put units into inventory Standard: 1,000 units Deluxe: 400 units Always zero dollars into inventory Flow of Costs in Variable Costing LO2: Explain how cost allocations affect income.

25. 25 LO2: Explain how cost allocations affect income.

26. 26 Flow of Costs in Absorption Costing LO2: Explain how cost allocations affect income. In Income StatementIn Balance Sheet Panel C: Absorption Costing Produce units Standard: 18,000 units Deluxe: 12,000 units Produce units Standard: 18,000 units Deluxe: 12,000 units Panel A: Physical flow of units Spend $5,040,000 on fixed manufacturing overhead Allocate to products Standard: $120/unit Deluxe: $240/unit 1,000 Standard * $120/unit + 400 Deluxe *240/unit = $216,000 7,000 Standard * $120/unit + 11,600 Deluxe * $240/unit = $4,824,000 Sell units Standard: 17,000 units Deluxe: 11,600 units Sell units Standard: 17,000 units Deluxe: 11,600 units Put units into inventory Standard: 1,000 units Deluxe: 400 units Put units into inventory Standard: 1,000 units Deluxe: 400 units

27. 27 LO2: Explain how cost allocations affect income.

28. 28 a)Be the same as it would be under absorption costing b)Be less than it would be under absorption costing c)Be equal to the net operating income using absorption costing plus selling and administrative costs d)Be equal to the net operating income using absorption costing less fixed manufacturing costs Test Your Knowledge! If a company produces more units than it sells in a period, net operating income under variable costing will:

29. 29 Comparing Profit All costs and revenues but for one kind of cost are accounted for in same way Fixed manufacturing overhead costs  Expensed under variable costing  Allocated to products under absorption costing when units are MADE  Expensed only when units are SOLD  Timing difference with inventory LO2: Explain how cost allocations affect income.

30. 30 a)Direct materials b)Variable manufacturing overhead c)Fixed manufacturing overhead d)Direct labor Test Your Knowledge! When using variable costing which of the following is not considered a product cost?

31. 31 Reconciling Income LO2: Explain how cost allocations affect income.

32. 32 Effect on Incentives Under Variable costing  Focus on controllability  Only sales affect income Under absorption costing  Focus on inventory valuation  Both sales and production affect income  Increase income by increasing production! LO2: Explain how cost allocations affect income.

33. 33 ALLOCATIONS: INCENTIVE EFFECTS

34. 34 Reimbursements Costs common among reimbursable and non-reimbursable reasons  Travel  Defense contracting  Hospital settings Choice of basis will affect amount reimbursed  Incentives to be strategic! LO3: Describe the role of incentives in the choice of allocation procedures.

35. 35 Example Ryan Supply Systems  Can allocate fixed costs via units or machine hours  Which is the preferred (profit maximizing) mechanism? LO3: Describe the role of incentives in the choice of allocation procedures.

36. 36 LO3: Describe the role of incentives in the choice of allocation procedures.

37. 37 Behavior Modification Allocations modify behavior  Can induce desired actions  Make undesired actions costly Allocation is like a “tax”  Increases the cost of the driver unit If “price” increases, demand decreases  Allocate on labor hours / labor cost  Reduce demand for labor  Allocate based on materials cost  Incentives to in-source LO3: Describe the role of incentives in the choice of allocation procedures.

38. 38 The allocation rate is $80 per machine hour. Thus, $4,400,000 would be allocated to public meals (= 0.55 x $8,000,000), and $3,600,000 would be allocated to the military contract (= 0.45 x $8,000,000). The gross margin for public meals is therefore $1,600,000 (= $16,000,000 - $10,000,000 - $4,400,000). The gross margin for the military is $2,320,000 (= [$8,000,000 + $3,600,000] x 0.20). The total gross margin = $1,600,000 + $2,320,000 = $3,920,000, which is still lower than the $4,400,000 total gross margin using meals as the allocation basis.

39. 39 Allocations are a “Tax” LO3: Describe the role of incentives in the choice of allocation procedures.

40. 40 Strategic Allocations By choosing pools and drivers strategically, we can use allocations to increase the amount cost allocated to some products  Of course, costs for other products will decrease Such allocations might be useful if one set of items has cost based pricing or reimbursements  Example: Defense contracting LO3: Describe the role of incentives in the choice of allocation procedures.

41. 41 Allocations and Behavior We can use this property to  Sensitize users to the long-term cost of a resource  Cost of support departments such as IT are allocated even if “fixed” in the short term  Discourage undesired behavior  Use some measure correlated with use as the basis  Use will go down as the “price” for the measure has increased  Encourage desired behavior  Suppose we want to tradeoff labor for materials cost  Using labor as an allocation basis provides the incentives to employees LO3: Describe the role of incentives in the choice of allocation procedures.

42. 42 WRAP UP

43. 43 Choices Depend on Why We Allocate LO3: Describe the role of incentives in the choice of allocation procedures.

44. 44 Conclusion Allocations pervasive in organizations Multiple reasons for why organizations allocate common costs  Only decision making related to controllability  Incentives drive the other demands for allocations Same allocation used for multiple purposes  When using allocation s to make decisions  Be aware of how allocations might help  How the validity of the choices affect estimated capacity cost  Consider incentive effects of the allocation mechanism in place LO3: Describe the role of incentives in the choice of allocation procedures.

45. 45 Exercise 9.32 Increase in volume of business and cost projections (LO1). David Sharma sells masks, textiles, and other goods imported from Africa. David usually marks up his purchases by 300% (that is, if he pays $10 for an item, he lists it at $40). His annual sales range from $1,400,000 to $1,700,000, with sales for the current year expected to be $1,500,000. He also incurs fixed costs related to the rental for his store, travel, and other items. Such fixed costs generally amount to $900,000 per year. Required: a)Suppose David anticipates sales of $1,700,000 next year. Calculate his expected profit for the current year and for next year, assuming that he does not change his pricing strategy. Use the contribution margin format. b)Suppose David anticipates sales of $2,800,000 next year because he expects African art to come into “fashion.” Calculate expected profit. The new level of fixed costs is $1,600,000. c)Why is it reasonable to think of fixed costs as being controllable when computing the answer for part (b) but not for part (a)? How might David reasonably estimate the “fixed” costs if he expects sales of $2,800,000 next year?

46. 46 a)Suppose David anticipates sales of $1,700,000 next year. Calculate his expected profit for the current year and for next year, assuming that he does not change his pricing strategy. Use the contribution margin format. The following table provides the required income statements. Exercise 9.32 (Continued) Notice that fixed costs remain at $900,000 even though the volume of operations has increased. This is a reasonable assumption – while fixed costs might increase some, they are not likely to increase dramatically because of a modest increase in sales.

47. 47 b)Suppose David anticipates sales of $2,800,000 next year because he expects African art to come into “fashion.” Calculate expected profit. The new level of fixed costs is $1,600,000. The following table provides the required statement. Exercise 9.32 (Continued)

48. 48 c)Why is it reasonable to think of fixed costs as being controllable when computing the answer for part (b) but not for part (a)? How might David reasonably estimate the “fixed” costs if he expects sales of $2,800,000 next year? Our view of “fixed” costs changes based on the volume of operation. David seems to have a normal range of operations of about $1.5 million. His fixed costs of $900,000 support operations at this level. However, the capacity provided by this expenditure is unlikely to support a much higher volume of sales. For instance, David might need to make more trips, spend more on stocking and tracking inventory, hire additional sales persons, open a branch outlet, and so on. All of these actions contribute to higher fixed costs. Exercise 9.32 (Continued)

49. 49 c)Why is it reasonable to think of fixed costs as being controllable when computing the answer for part (b) but not for part (a)? How might David reasonably estimate the “fixed” costs if he expects sales of $2,800,000 next year? This problem reinforces that “fixed” costs are fixed only for a given volume of operations and for a given time frame. These costs do become controllable if we significantly change the volume of operations or consider a long time frame. In David’s case, estimating the higher fixed cost might be hard. One reasonable approach is to say that fixed costs are 60% of sales revenue ($900,000/$1,500,000). Then, at a volume of $2.8 million in sales, David would estimate fixed costs at $1,680,000. Exercise 9.32 (Continued)

50. 50 c)Why is it reasonable to think of fixed costs as being controllable when computing the answer for part (b) but not for part (a)? How might David reasonably estimate the “fixed” costs if he expects sales of $2,800,000 next year? Note: Part (b) provides an estimate of $1.6 million toward fixed costs. The difference underscores that using an allocation to project capacity costs assumes that the underlying relation would be the same. In David’s case, it is likely that, because of scale economies, fixed costs do not increase proportionately with sales volume. Methods such as direct estimation are better equipped to deal with such effects, but require more effort and expertise. Exercise 9.32 (Concluded)