1. © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 4 Cost Accumulation, Tracing, and Allocation

2. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-2 Chapter Opening Managers must have reliable cost estimates to: Price products. Evaluate performance. Control operations. Prepare financial statements. Managers must have reliable cost estimates to: Price products. Evaluate performance. Control operations. Prepare financial statements. What does it cost?

3. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-3 Learning Objective LO1 To identify cost objects and cost drivers

4. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-4 Determine the Cost of Cost Objects Cost accumulation begins with identifying: 1.Cost objects 2.Cost drivers A cost object is any activity, product, or service to which accountants wish to trace costs.

5. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-5 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

6. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-6 Accumulated Minutes Rate per Cost Talked Minute Minutes Talked Total Long Distance Telephone Bill =  Minutes talked is the cost driver. Use of Cost Drivers to Accumulate Costs

7. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-7 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.

8. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-8 Estimated Versus Actual Cost Potential Inaccuracies TimelyRelevant Estimated Costs Managers use estimated costs to make decisions about the future.

9. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-9 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

10. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-10 Learning Objective LO2 To distinguish direct costs from indirect costs

11. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-11 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 and Indirect Costs

12. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-12 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 and Indirect Costs

13. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-13 Identifying Direct and Indirect Costs

14. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-14 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’s salary is indirect to any one department, but is directly traceable to the store. Identifying Direct and Indirect Costs

15. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-15 Learning Objective LO3 To allocate indirect costs to cost objects

16. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-16 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. The cost drivers of In Style, Inc. are:

17. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-17 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.

18. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-18  $9,360 ÷ 3 departments = $3,120 per department  $3,120 × 1 department = $3,120 Allocating Indirect Costs to Departments

19. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-19  $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

20. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-20  $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

21. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-21  $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

22. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-22  $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

23. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-23 Now let’s combine the costs and revenues and see how departmental profitability looks. Allocating Indirect Costs to Departments

24. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-24 Allocating Indirect Costs to Departments

25. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-25 Learning Objective LO4 To select appropriate cost drivers for allocating indirect costs

26. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-26 An “Activity” is any task that an organization undertakes to make or deliver a good or service. A “cost driver” is an activity or event that causes costs to be incurred. Number of printers made by HP in a day Number of flights by Jet Blue each day Selecting a Cost Driver

27. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-27 Behavioral Implications Cost allocations may affect departmental profits. Performance evaluations may be based on departmental profits. Department managers may make decisions to enhance their performance evaluations.

28. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-28 Effects of Cost Behavior on Selecting a Cost Driver Does this mean that I should use different cost drivers for variable and fixed overhead?

29. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-29 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

30. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-30 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

31. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-31  $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

32. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-32  $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

33. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-33  $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

34. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-34 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.

35. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-35 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.

36. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-36 Allocating Fixed Overhead Costs Lednicky Bottling Company Information Use the two-step process to allocate the fixed rental cost to units sold and to units in ending inventory.

37. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-37 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

38. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-38 Learning Objective LO5 To allocate costs to solve timing problems

39. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-39 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 priced higher than those produced in February. Will customers think this is reasonable? Allocating Costs to Solve Timing Problems

40. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-40 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 for 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.

41. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-41 Learning Objective LO6 To allocate joint product costs

42. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-42 Allocating Joint Costs Joint Costs Product

43. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-43 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

44. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-44 Consider the following example of an oil refinery. We will assume only two products, gasoline and oil. Allocating Joint Costs

45. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-45 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

46. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-46 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

47. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-47 Relative Sales Value Method

48. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-48 Relative Sales Value Method

49. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-49 $225,000 joint conversion cost plus $275,000 joint material cost Relative Sales Value Method

50. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-50 Learning Objective LO7 To recognize the effects of cost allocation on employee motivation

51. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-51 Cost Allocation: The Human Factor Is it fair to divide the College of Business’s copy budget equally? I think we should consider the number of faculty. I think we should consider the number of students.

52. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-52 Let’s see how the allocation of budgeted amounts will effect the different departments. We will begin by allocating equal amounts. Cost Allocation: The Human Factor

53. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-53 Cost Allocation: The Human Factor Who is happy? Who is unhappy?

54. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-54 Cost Allocation: The Human Factor Now let’s allocate the $36,000 budget based on the number of faculty in each department.

55. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-55 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

56. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-56 Cost Allocation: The Human Factor Now let’s allocate the $36,000 budget based on the number of students in each department.

57. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-57 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

58. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-58 Controlling Emotions A compromise that bases a portion of the allocation on the number of faculty with the balance allocated based on the number of students might solve the problem. Technical expertise in computing numbers is of little use without the interpersonal skills to persuade others.

59. The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 4-59 End of Chapter 4