7-1 Designing Product Cost Systems C hapter 7 Prepared by Douglas Cloud Pepperdine University.

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Designing Designing Product Cost Product Cost

SystemsSystems

Designing Designing Product Cost Product Cost

SystemsSystems

CChaptehapterr

77

Prepared by Douglas Cloud

Pepperdine University

Prepared by Douglas Cloud

Pepperdine University

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1. Define and explain the primary elements of an indirect cost allocation system.

2. Describe the process of allocating service department costs, including the treatment of interdepartmental services.

3. Compare and contrast activity-based costing (ABC) and traditional organizational-based costing (OBC).

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

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4. Calculate overhead rates under three methods on the product costing continuum using a plantwide rate, departmental rates, or activity-based rates.

5. Discuss the issue associated with implementing an activity-based costing system.

6. Explain the uses and evolution of ABC.

ObjectivesObjectivesObjectivesObjectives

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Controlling Indirect CostsControlling Indirect CostsControlling Indirect CostsControlling Indirect CostsThe purpose of this chapter is to

explore the nature of indirect costs and frequently used approaches to

reassigning indirect costs to products or services.

The purpose of this chapter is to explore the nature of indirect costs and frequently used approaches to

reassigning indirect costs to products or services.

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Allocating Indirect CostsAllocating Indirect CostsAllocating Indirect CostsAllocating Indirect Costs

Costs incurred for the common benefit of all occupants of a

building is an indirect, or common cost.

Costs incurred for the common benefit of all occupants of a

building is an indirect, or common cost.

A cost objective is anything to which costs are assigned, e.g., the cost of inspecting incoming raw materials.

A cost objective is anything to which costs are assigned, e.g., the cost of inspecting incoming raw materials.

A cost pool is a collection of related costs that is assigned to

one or more cost objectives.

A cost pool is a collection of related costs that is assigned to

one or more cost objectives.

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Cost Allocation BaseCost Allocation BaseCost Allocation BaseCost Allocation Base

Indirect Cost Category Allocation BaseEmployee health services Number of employees or

visitsPersonnel Number of employees or

new hires

Maintenance and repairs Number of repair orders or service hours

Purchasing Number of orders placed

Warehouse Square footage used or value of materials stored

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Production and Service Production and Service Department CostsDepartment Costs


Departments which provide support services to

production and/or other support departments are

called service departments.

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A direct department cost is a cost assigned

directly to a department (production service) when it is incurred.

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An indirect department cost is a cost assigned

directly to a department as a result of an indirect

allocation, or reassignment from

another department or cost object.

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Direct MethodDirect MethodDirect MethodDirect Method

Flow of Costs

Support Support ServicesServices

Building and Building and GroundsGrounds

Service Departments

Engineering Engineering ResourcesResources

Product Product Product

Mixing Bottling Producing Departments

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SupportServices Mixing Bottling

Departmental cost before allocations $27,000 $40,000 $ 90,000Support Services -27,000

Allocation based on invested capital


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Departmental cost before allocations Support Services -27,000 10,800

$180,000/$450,000 x $27,000


$27,000 $40,000 $ 90,000

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Departmental cost before allocations Support Services 27,000 10,800 16,200

$270,000/$450,000 x $27,000


$27,000 $40,000 $ 90,000

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Engineering Resources Mixing Bottling

Departmental cost before allocations $20,000 $40,000 $ 90,000Support Services 10,800 16,200


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Departmental cost before allocations $20,000 $40,000 $ 90,000Support Services 10,800 16,200Engineering Resources -20,000

Allocation based on number of employees


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Departmental cost before allocations $20,000 $40,000 $ 90,000Support Services 10,800 16,200Engineering Resources -20,000 6,000

24/80 x $20,000


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Departmental cost before allocations $20,000 $40,000 $ 90,000Support Services 10,800 16,200Engineering Resources -20,000 6,000 14,000

56/80 x $20,000


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Building and Grounds Mixing Bottling

Departmental cost before allocations $10,000 $40,000 $ 90,000Support Services 10,800 16,200Engineering- Resources 6,000 14,000Building and Grounds -10,000


Allocation based on squared footage occupied

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Departmental cost before allocations $10,000 $40,000 $ 90,000Support Services 10,800 16,200Engineering Resources 6,000 14,000Building and Grounds -10,000 2,500


25% x $10,000

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Departmental cost before allocations $10,000 $40,000 $ 90,000Support Services 10,800 16,200Engineering Resources 6,000 14,000Building and Grounds -10,000 2,500 7,500


75% x $10,000

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Departmental cost before allocations $10,000 $40,000 $ 90,000Support Services 10,800 16,200Engineering Resources 6,000 14,000Building and Grounds -10,000 2,500 7,500Departmental costs after allocation $ 0 $59,300 $127,700


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The step method gives partial recognition of

interdepartment services.

The step method gives partial recognition of

interdepartment services.

Step MethodStep MethodStep MethodStep Method

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Engineering Engineering ResourcesResources

Building and Building and GroundsGrounds

Service Departments

Support Support ResourcesResources


Mixing Bottling Producing Departments


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Engineering Support Building & Resources Services Grounds Mixing Bottling

$20,000 $27,000 $ 10,000 $40,000 $ 90,000First, let’s examine the

departmental costs before allocation.

First, let’s examine the departmental costs before allocation.


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$20,000 $27,000 $ 10,000 $40,000 $ 90,000

Engineering Support Building & Resources Services Grounds Mixing BottlingThe Engineering

Resources Department’s cost is allocated on the

basis of number of employees.

The Engineering Resources Department’s cost is allocated on the

basis of number of employees.


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$20,000 $27,000 $ 10,000 $40,000 $ 90,000

(20,000) 3,000 1,000 4,800 11,200

5/100 x $20,000 24/100 x $20,000 56/100 x $20,00015/100 x $20,000


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$20,000 $27,000 $ 10,000 $40,000 $ 90,000

(20,000) 3,000 1,000 4,800 11,200

Next, the Support Service Department is

allocated based on capital investment.

Next, the Support Service Department is

allocated based on capital investment.


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$20,000 $27,000 $ 10,000 $40,000 $ 90,000

(20,000) 3,000 1,000 4,800 11,200

(30,000 3,000 10,800 16,200)

$50,000/$500,000 x $30,000$180,000/$500,000 x $30,000 $270,000/$500,000 x $30,000


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Step MethodStep MethodStep MethodStep Method Engineering Support Building & Resources Services Grounds Mixing Bottling

$20,000 $27,000 $ 10,000 $40,000 $ 90,000

(20,000) 3,000 1,000 4,800 11,200

(30,000 3,000 10,800 16,200)

Finally, the Building and Grounds Department is

allocated to the production departments on the bases of

square footage.

Finally, the Building and Grounds Department is

allocated to the production departments on the bases of

square footage.

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$20,000 $27,000 $ 10,000 $40,000 $ 90,000

(20,000) 3,000 1,000 4,800 11,200

(30,000 3,000 10,800 16,200

(14,000 3,500 10,500

)

)

11,000/44,000 x $14,000 33,000/44,000 x $14,000


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$20,000 $27,000 $ 10,000 $40,000 $ 90,000

(20,000) 3,000 1,000 4,800 11,200

(30,000 3,000 10,800 16,200

(14,000 3,500 10,500

$ 0 $ 0 $59,100 $127,900

)

)

$ 0


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Linear Algebra MethodLinear Algebra MethodLinear Algebra MethodLinear Algebra Method

The linear algebra method uses a series of linear algebraic equations, which are

solved simultaneously, to allocate service cost interdepartmentally and to

the producing departments.

The linear algebra method uses a series of linear algebraic equations, which are

solved simultaneously, to allocate service cost interdepartmentally and to

the producing departments.

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Producing Departments

Flow of Costs

Service Departments

S1 S2

P1 P2

Linear Algebra MethodLinear Algebra MethodLinear Algebra MethodLinear Algebra Method

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Activity-Based and Activity-Based and Organization-Based CostingOrganization-Based Costing


Traditional costing considers the cost of a product to be its direct

costs for materials and...

Traditional costing considers the cost of a product to be its direct

costs for materials and...

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… labor, plus some allocated portion of factory overhead.

… labor, plus some allocated portion of factory overhead.



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In OBC, overhead rates are allocated to products using a plant-wide or departmental

overhead rates.

In OBC, overhead rates are allocated to products using a plant-wide or departmental

overhead rates.

In brief, cost assignment follows the organization chart.

In brief, cost assignment follows the organization chart.

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ABC costing is based on the notion that companies incur

costs because of the activities they conduct in pursuit of their goals and objectives.

ABC costing is based on the notion that companies incur

costs because of the activities they conduct in pursuit of their goals and objectives.

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In many OBC systems, overhead is assigned no one or more cost pools, and then reassigned to products using

a general allocation base.

In many OBC systems, overhead is assigned no one or more cost pools, and then reassigned to products using

a general allocation base.

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ABC Two-Stage Costing ModelABC Two-Stage Costing Model

Continued on next slideContinued on next slide

Department 1 Department 1 Direct product Direct product

costscosts

Department 2 Department 2 Direct product Direct product

costscosts

Department N Department N Direct product Direct product

costscosts

Department 1 Indirect costs


Department N Indirect cost

$ $ $ $ $$

Resource Costs

to Cost of Product

Activity Cost Pools

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$ $ $ $ $$

Second stage: Second stage: Costs assigned to activities are reassigned Costs assigned to activities are reassigned to cost objectives using an activity cost to cost objectives using an activity cost driver.driver.



Department N Indirect cost

Cost of productsCost of products

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Using OBC AllocationUsing OBC AllocationUsing OBC AllocationUsing OBC Allocation

1. Maintenance department costs would typically be allocated to production departments based on the number of repair orders or the number of service hours associated with repairs done in each production department.

2. Purchasing department costs may be allocated to production departments based on the dollar value of raw materials issued to each department.

3. In a pure OBC system, department costs are allocated first to the producing departments using the direct, step, or linear algebra method.

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Conclusions of Activity-Conclusions of Activity-Based CostingBased Costing

Conclusions of Activity-Conclusions of Activity-Based CostingBased Costing

ABC normally uses a greater of costs pools than OBC allocation methods.

ABC does not use the established departmental structure for pooling costs unless that structure happens to coincide with key activities.

ABC is more insistent on the use of causal factors than OBC.

ContinuedContinuedContinuedContinued

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ABC assigns costs based on their activity cost drivers, and if cost drivers cannot be identified and measured, ABC cannot be used to assign those costs.

Implementation of ABC requires an understanding of the production process, the activities that occur in the production process, and the cost drivers that generate the costs of those activities.

Implementation and operation of ABC is more likely to involve the use of judgment than the operation of an OBC system.

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Product Costing ContinuumProduct Costing ContinuumProduct Costing ContinuumProduct Costing Continuum

Organization-Based Costing (OBC) Activity-Based Costing (ABC)

Plant-Wide Overhead

Departmental Overhead Rate Methods

Two-Stage Models

Multiple Stage Models

Simple Complex

Imprecise Precise

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The Product Costing The Product Costing Continuum IllustratedContinuum IllustratedThe Product Costing The Product Costing

Continuum IllustratedContinuum Illustrated

Krown Drink produced 232 barrels of Carbonated drink and 400 barrels of Fruit drink. Estimated manufacturing overhead is $187,000

and estimated machine hours total 1,496.

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Overhead rate =$187,000

1,496

Overhead rate = $125 per m/h



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Direct materials $125 $120

Direct labor 110 30

Manufacturing overhead:

Carbonated (3 x $125) 375

Fruit (2 x $125) 250

Total unit cost $610 $400

Unit Costs

Carbonated Fruit



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Applying Overhead withApplying Overhead with Departmental Rates Departmental Rates


Total Departmental Manufacturing

Overhead $59,100 $127,900Quantity of Base:

Direct Labor Hours 500Machine Hour 800

Overhead Rates $118.20 $159.875

Mixing Bottling

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Direct labor 110 30

Manufacturing overhead:

Mixing (l/h x $118.20) 118 79

Bottling (m/h x $159.875) 160 227

Total costs $513 $456

Unit Costs

Carbonated Fruit



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Overhead Activity and Cost

Direct departmental overhead costs:Mixing $40,000/500 = $80 per labor hourBottling $90,000/800 = $112.50 per m/h

Common overhead costs:Support Services:

Receiving $14,000/100 = $140 per orderInventory Control $13,000/632 = $20.57 per

unit

Unit Activity Rates

ContinuedContinued



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Overhead Activity and Cost

Engineering Resources:Production Setup $12,000/20 = $600 per runEngineering and Testing $8,000/800 = $10 per m/h

Building and Grounds:Maintenance, machines $4,000/800 = $5 per m/hDepreciation, machines $6,000/632 = $9.49 per unit

Unit Activity Rates



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CarbonatedMixing ($80 x 232 labor hours) $18,560Bottling ($112.50 x 174 machine hours) 19,575Receiving ($140 x 40 orders) 5,600Inventory control ($20.57 x 232 units) 4,772Production setup ($600 x 5 runs) 3,000Engineering and Testing ($10 x 174 m/h) 1,740Maintenance, machines ($5 x 174 units) 870Depreciation, machines ($9.49 x 232 units) 2,202

Total factory overhead product cost $56,319Factory overhead cost per unit ($56,319/232) $243



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Fruit Mixing ($80 x 268 labor hours) $ 21,440Bottling ($112.50 x 626 machine hours) 70,425Receiving ($140 x 60 orders) 8,400Inventory control ($20.57 x 400 units) 8,228Production setup ($600 x 15 runs) 9,000Engineering and Testing ($10 x 626 m/h) 6,260Maintenance, machines ($5 x 626 units) 3,130Depreciation, machines ($9.49 x 400 units) 3,796

Total factory overhead product cost $130,679Factory overhead cost per unit ($130,679/400) $327



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Direct labor 110 30

Manufacturing overhead 243 327

Total costs using ABC $478 $477

Unit Costs

Carbonated Fruit



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Practical Advice for Implementing ABCPractical Advice for Implementing ABCPractical Advice for Implementing ABCPractical Advice for Implementing ABC

1. Capture the attention of top management.

2. Don’t shoot the customer.

3. Decide the form ABC will take.

4. Supplement the ABC measures creativity where appropriate.

5. Be careful in costing bottlenecks that create excess capacity.

6. Challenge managers who believe their costs are fixed.

7. Calculate costs top-down and bottom-up.

8. Account for cost of capital.

9. Use multi-functional teams.

10.Don’t underestimate the need for managing change.

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CChapter

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The The EndEndThe The EndEnd

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7-1 Designing Product Cost Systems C hapter 7 Prepared by Douglas Cloud Pepperdine University.

Documents

indirect department

indirect costs costs

common cost

bottling departmental

cost pool

cost objectives

objectivesobjectives

continuedcontinued slide