© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Chapter 21 Cost Allocation and Performance Measurement.

© The McGraw-Hill Companies, Inc., 2007McGraw-Hill/Irwin

Chapter 21

Cost Allocation and Performance Measurement


Conceptual Learning Objectives

C1: Explain departmentalization and the role of departmental accounting

C2: Distinguish between direct and indirect expenses

C3: Identify bases for allocating indirect expenses to departments

C4: Explain controllable costs and responsibility accounting

C5: Appendix 21A: Describe allocation of joint costs across products


A1: Analyze investment centers using return on total assets

P1: Assign overhead costs using

two-stage cost allocation

P2: Assign overhead costs using activity-based

costing

P3: Prepare departmental income statements

P4: Prepare departmental contribution reports

Analytical Learning Objectives


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.

Assigningoverhead is

difficult. I agree!

Overhead Cost Allocation Methods

P1


A two-stage process maybe used because different

departments may have different allocation bases.

A two-stage process maybe used because different

departments may have different allocation bases.

Finishing Department

Shipping Department

Painting Department

Two-Stage Cost AllocationP1


IndirectMaterials

OtherOverhead

IndirectLabor

Department1

Department2

Department3

Stage One:Costs assignedto departments

Two-Stage Cost AllocationP1



Two-Stage Cost AllocationIndirect

MaterialsOther

OverheadIndirectLabor

Department1

Department2

Department3

P1




MaterialsOther


Department1

Department2

Department3

P1


Stage Two:Costs applied

to jobs


Jobs


MaterialsOther


Department1

Department2

Department3

P1


Jobs

Direct Labor Hours

MachineHours

RawMaterials

Cost

Departmental Allocation Bases

Stage Two:Costs applied

to jobs



MaterialsOther


Department1

Department2

Department3

P1


Level of C

omplexity

Level of C

omplexity

Overhead Allocation

Plantwide Overhead

Rate

DepartmentalOverhead

Rates

Activity BasedCosting

Activity-Based Cost AllocationP2


In the ABC method, we recognize that many

activities within a department drive overhead costs.

In the ABC method, we recognize that many

activities within a department drive overhead costs.A

B CA

CB

P2

Activity-Based Cost Allocation


Identify activities and assign indirect costs to those activities.

Central idea . . . Products require activities. Activities consume resources. A

B CA

CB

Activity-Based CostingP2


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 comparedto 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 comparedto costs of implementation.

Activity-Based Costing BenefitsP2


Most cost drivers are related to either volume or complexity of production. Examples: machine time, machine setups, purchase

orders, production orders.

Three factors are considered in choosing a cost driver: Causal relationship. Benefits received. Reasonableness.

Most cost drivers are related to either volume or complexity of production. Examples: machine time, machine setups, purchase

orders, production orders.

Three factors are considered in choosing a cost driver: Causal relationship. Benefits received. Reasonableness.

Identifying Cost DriversP2


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

Activity-Based Costing Procedures

P2


Let’s look at anexample comparingtraditional costing

with ABC. We will start with

traditional costing.



Pear Company manufactures a product 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:

First, determine the unit cost of each model using traditional costing methods.

Traditional Costing vs. ABCExample

P2


Overhead Estimated overhead costs Rate Estimated activity

=

Overhead $2,000,000 Rate 40,000 DLH

= = $50 per DLH

P2

Traditional Costing


Deluxe RegularModel Model

Direct Material 150$ 112$ Direct Labor 16 8 Manufacturing Overhead$50 per hour × 1.6 hours 80 $50 per hour × 0.8 hours 40 Total Unit Cost 246$ 160$

ABC will have differentoverhead per unit.

Traditional CostingP2


Pear 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.



Overhead UnitsActivity Cost Cost for ofCenter Driver Activity Activity Rate

Purchasing Orders 84,000$ 1,200 Scrap Rework Orders 216,000 900 Testing Tests 450,000 15,000 Machine Related Hours 1,250,000 50,000 Total Overhead 2,000,000$

400 deluxe + 800 regular = 1,200 total



Overhead UnitsActivity Cost Cost for ofCenter Driver Activity Activity Rate

Purchasing Orders 84,000$ 1,200 $ 70 per orderScrap Rework Orders 216,000 900 $240 per orderTesting Tests 450,000 15,000 $ 30 per testMachine Related Hours 1,250,000 50,000 $ 25 per hourTotal Overhead 2,000,000$

Rate = Overhead Cost for Activity ÷ Units of Activity





Let’s completethe table.





Total overhead = $720,000 + $1,280,000 = $2,000,000Recall that $2,000,000 was the original amount of

overhead assigned to the products using traditional overhead costing.





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.

Traditional Costing ABCDeluxe Regular Deluxe RegularModel Model Model Model

Direct labor 150$ 112$ 150$ 112$ Direct material 16 8 16 8 Overhead 80 40 144 32 Total cost 246$ 160$ 310$ 152$

Traditional Costing vs. ABCP2


Cost Cost DriverMaterials purchasing Number of purchase ordersMaterials handling Number of materials

requisitionsPersonnel processing Number of employees hired

or laid offEquipment depreciation Number of products

produced or hours of useQuality inspection Number of units inspectedIndirect labor for Number of setups required equipment setupsEngineering costs for Number of modifications product modifications

Costs and Cost Drivers inActivity-Based Costing

Exh. 21-6

P2


Provide informationfor managers to use

in performanceevaluation.

Provide informationfor managers to use

in performanceevaluation.

Assign costs tomanagers who are

responsible forcontrolling the costs.

Assign costs tomanagers who are

responsible forcontrolling the costs.

Primarygoals

Departmental AccountingC1


Large complex businesses are

divided into departments

enabling managers to have a smaller effective span of

control.



Departments areestablished for

specialized functions.


Production Sales Service


Managers use this information to: Control operations

Appraise performance

Allocate resources.

Plan strategy

The accounting system provides information about resources used and outputs achieved. The accounting system provides information about resources used and outputs achieved.

Information forDepartmental Evaluation

C1


The type of accounting information provided depends on whether the department is a . . .

The type of accounting information provided depends on whether the department is a . . .

Evaluated on ability to

control costs.

Evaluated on ability to

control costs.

Evaluated on abilityto generate revenues

in excess of expenses.

Evaluated on abilityto generate revenues

in excess of expenses.

Costcenter

Profitcenter


C1


Quality CustomerSatisfaction

ProfitabilityCost

Effectiveness

Information must support these four pillars of

any successful business


C1


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.

Departmental Expense Allocation

C2


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.

Illustration of IndirectExpense Allocation

Exh. 21-7

C2



Exh. 21-7


C2



Exh. 21-7


C2


Service department costs are shared, indirect expenses that support the activities of two or more production departments.

Bases for AllocatingService Department Costs

Exh. 21-8

C3


ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly?a. $100,000b. $120,000c. $150,000d. $180,000


Service Department CostsQuestion

C3




Assembly percentage= 100 ÷ (100 + 150) = 40%

40% of $300,000 = $120,000

Service Department CostsQuestion

C3


Preparing DepartmentalIncome Statements

P3

Let’s prepare departmental income statements using the following steps:

Direct expense accumulation. Indirect expense allocation. Service department expense allocation


Service Dept. One

Service Dept. Two

Operating Dept. One

Direct expenses are traced to eachdepartment without allocation.

Operating Dept. Two

Step 1: Direct Expense Accumulation

P3


Service Dept. One

Service Dept. Two

Operating Dept. One

Indirect expenses are allocated to all departmentsusing appropriate allocation bases.

Allocation Allocation Allocation Allocation

Step 2: Indirect Expense Allocation

Operating Dept. Two

P3


Operating Dept. One

Operating Dept. Two

Service department total expenses (original direct expenses + allocated indirect expenses) are

allocated to operating departments.

Allocation Allocation

Service Dept. One

Service Dept. Two

Step 3: Service Department Expense Allocation

P3


Departmental ExpenseAllocation Spreadsheet

P3

Let’s examine this three-step allocation procedure forOwl Company.



Expense Allocation to DepartmentsService Service Sales Sales

Allocation Total Dept. Dept. Dept. Dept.Base Expense One Two One Two

Direct expenses Salaries Payroll 20,000$ 1,000$ 2,000$ 6,000$ 11,000$ Supplies Requisitions 1,500 100 300 400 700

Step 1: Direct expenses are traced to service departments and sales departments without allocation.

P3





Direct expenses Salaries Payroll 20,000$ 1,000$ 2,000$ 6,000$ 11,000$ Supplies Requisitions 1,500 100 300 400 700 Indirect expenses Rent Floor space 10,000 1,000 1,000 3,000 5,000 Utilities Floor space 1,000 100 100 300 500 Total dept. expenses 32,500$ 2,200$ 3,400$ 9,700$ 17,200$

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.

P3





Service dept. expenses Service Dept. One Sales (2,200) 1,000 1,200 Service Dept. Two EmployeesTotal expenses 32,500$ $ 0 3,400$ 10,700$ 18,400$

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.


P3






Service dept. expenses Service Dept. One Sales (2,200) 1,000 1,200 Service Dept. Two Employees (3,400) 1,400 2,000 Total expenses 32,500$ $ 0 $ 0 12,100$ 20,400$

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.

P3





Service dept. expenses Service Dept. One Sales (2,200) 1,000 1,200 Service Dept. Two Employees (3,400) 1,400 2,000 Total expenses 32,500$ $ 0 $ 0 12,100$ 20,400$


P3


.

DepartmentalIncome Statements

P3

Now that we have the costs, let’s do an income statement


Sales SalesCombined Dept. One Dept. Two

Sales 88,000$ 40,000$ 48,000$ Cost of goods sold 38,000 20,000 18,000 Gross profit on sales 50,000$ 20,000$ 30,000$ Operating expenses Salaries 17,000$ 6,000$ 11,000$ Supplies 1,100 400 700 Rent 8,000 3,000 5,000 Utilities 800 300 500


P3



Sales SalesCombined Dept. One Dept. Two

Sales 88,000$ 40,000$ 48,000$ Cost of goods sold 38,000 20,000 18,000 Gross profit on sales 50,000$ 20,000$ 30,000$ Operating expenses Salaries 17,000$ 6,000$ 11,000$ Supplies 1,100 400 700 Rent 8,000 3,000 5,000 Utilities 800 300 500 Service Department One 2,200 1,000 1,200 Service Department Two 3,400 1,400 2,000 Total operating expenses 32,500$ 12,100$ 20,400$ Net income 17,500$ 7,900$ 9,600$

P3


Departmental contribution . . . Is used to evaluate departmental performance. Is not a function of arbitrary allocations of

indirect expenses.

A department may be eliminated when its departmental contribution is negative.

Departmental revenue– Direct expenses = Departmental contribution

Departmental revenue– Direct expenses = Departmental contribution

Departmental Contributionto Overhead

P3


As a general rule, a department canbe considered a candidate forelimination if its revenues are lessthan its escapable expenses.

Direct expenses are usually escapable.

Indirect expenses are usually inescapable.

Eliminating anUnprofitable Department

P3



P4

Let’s recast Owl Company’s income statement

using the departmental contribution approach

where indirect expenses are not allocated.


Net income for the company is

still $17,500.


P4


Departmental contributions to indirect expenses

(overhead) are emphasized.


P4


Departmental contributions are positive so neither department is a candidate for elimination.


P4


Costs are controllableif the manager

has the power to determine, or strongly influence, the

amounts incurred.

A manager’s performance evaluation should be based

on controllable costs.

Controllable CostsC4


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.

Controllable costs are identified with a particular manager and a definite time period. All costs are controllable at some level of

management if the time period is long enough.

Distinguishing Controllableand Direct Costs

C4


An accounting system thatprovides information . . .

Responsibility Accounting

Relating to theresponsibilities of

individual managers.

To evaluatemanagers on

controllable items.

C4


Responsibility Accounting Successful implementation of responsibility accounting may use organization charts with

clear lines of authority and clearly defined levels of responsibility.

Successful implementation of responsibility accounting may use organization charts with

clear lines of authority and clearly defined levels of responsibility.

Vice Presidentof F inance

D epartm ent M anager

Store M anager

V ice Presidentof O perations

V ice Presidentof M arketing

President

B oard of D irectors

C4


Amount of detail varies according to level in organization.

A department manager receives detailed reports.

A store manager receives summarized information from each department.

Responsibility AccountingPerformance Reports

C4


The vice president of operations receives summarized information

from each store.

Management by exception:

Upper-level management does not receive operating

detail unless problems arise.

Amount of detail varies according to level in organization.


C4


To be of maximum benefit, responsibility reports should . . . Be timely. Be issued regularly. Be understandable. Compare budgeted

and actual amounts.


C4


A single cost incurred in producing or purchasing two or more different products. Similar to an indirect expense

since it is shared among morethan one cost object.

Example: The cost of crudeoil is a joint cost for manypetrochemical products.

Joint CostsC5


If we allocate the joint costs of raising the animal to the two products based on weight, which product

would receive the largest cost allocation?

Joint Costs and Their Allocation

Hamburger, because there is more of it.

C5


If we allocate the joint costs of raising the animal to the two products based on sales value, would the

steak receive a greater portion of the cost allocation?

Yes, steak has a higher sales value than hamburger.

Joint Costs and Their Allocation

C5


Allocate the $200,000 joint cost based on sales value.

Product OneSales value = $80,000

Product TwoSales value = $200,000

Product ThreeSales value = $120,000

$200,000Joint Cost

Value Basis Allocation of Joint Costs

C5


Value Basis Allocation of Joint Costs

C5


End of Chapter 21

© The McGraw-Hill Companies, Inc., 2007 McGraw-Hill/Irwin Chapter 21 Cost Allocation and Performance Measurement.

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