CH 06

CHAPTER
CHAPTER 66
Cost Allocation
&
Activity-Based Costing
Slide 6-2
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
To provide information for decision
making
To reduce frivolous use of common
resources
To encourage evaluation of services
To provide full cost information
Slide 6-3
Learning objective 1: Explain why indirect

costs are allocated
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Slide 6-4

costs are allocated
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Provide information for decision making
Allocated cost should measure the
opportunity cost of using a company resource
In practice, difficult to operationalize since
cost may quickly change
Provides a useful benchmark
Slide 6-5

costs are allocated
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Reduce frivolous use of common resources
Frivolous use may have hidden cost such as
slower service
Allocation of centrally provided services
provides incentive for departments to reduce
frivolous use of resource
Slide 6-6

costs are allocated
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Encourage evaluation of services
If costs are not allocated, there is no incentive
to evaluate the services and look for lower cost
alternatives
With cost allocation, there is a strong
incentive to critically evaluate the efficiency
and necessity of services
Slide 6-7

costs are allocated
Purposes
Purposes of
of Cost
Cost Allocation
Allocation
Provide full cost information
GAAP requires full costing for external
reporting purposes
Full cost information is needed when the
company has an agreement whereby revenue
received depends upon cost incurred,
i.e.cost-plus contracts
Slide 6-8

costs are allocated
Cost-Plus
Cost-Plus Contracts
Contracts
Slide 6-9

costs are allocated
Process
Process of
of Cost
Cost Allocation
Allocation
Determine the cost objective
Form cost pools
Select an allocation base to relate
cost pools to the cost objective
Slide 6-10
Learning objective 2: Describe the

cost allocation process
Process
Process of
of Cost
Cost Allocation
Allocation
Slide 6-11

Determine
Determine the
the Cost
Cost Objective
Objective
Determine the product, service, or
department that is to receive the
allocation. Object of the allocation is
called the cost objective
For example, if computer costs are
allocated to contracts, the contracts are
the cost objective
Slide 6-12

Cost
Cost Objectives
Objectives
Slide 6-13

In the cost allocation process, the cost

objective is the:
a. The allocation base used to allocate the costs
b. A grouping of individual costs whose total is
allocated using one allocation base
c. The product, service or department that is to
receive the allocation
d. None of the above
Answer: c
The product, service or department that is to
receive the allocation
Slide 6-14

Form
Form Cost
Cost Pools
Pools
A grouping of individual costs whose total
is allocated using one allocation base
Costs in the pool must be homogeneous
(similar)
Cost pools can be organized along
-departmental lines, e.g. Maintenance,
Personnel depts.
-major activities, e.g. equipment setups,
inspections.
Slide 6-15

Select
Select an
an Allocation
Allocation Base
Base
Select an allocation base that relates cost
pool to the cost objectives
-base must be some characteristic that is
common to all of the cost objectives
-should be based on cause-and-effect
relationship
If indirect costs are fixed, cause-andeffect relationships are difficult to

establish and other approaches are used
Slide 6-16

Select
Select an
an Allocation
Allocation Base
Base
Two production departments: Assembly
and Finishing
- both receive allocations of indirect costs from
the maintenance department
- should labor hours or machine hours be used
as the allocation base?
Slide 6-17

Selecting
Selecting an
an Allocation
Allocation Base
Base
Slide 6-18

In the cost allocation process, an allocation

base:
a. Must be some characteristic that is common
to all of the cost objectives
b. Ideally should result in cost being allocated
based on a cause-and-effect relationship
c. Both a and b
d. None of the above
Answer: c Both a and b
Slide 6-19

Fixed
Fixed Indirect
Indirect Costs
Costs
Other
Other
Approaches
Approaches
Relative benefits approach to allocation
- More costs allocated to those objectives that
benefit most from incurring the cost
Ability to bear costs

- More costs allocated to those that are more
profitable
Equity approach to allocation

- Base results in allocations that are perceived to
be fair or equitable
Slide 6-20

Allocating
Allocating Service
Service Department
Department
Costs
Costs
Organizational units of manufacturing
firms classified as either:
- production departments, or
- service departments
Cost pools
- formed by service departments
- Allocated to production departments
Slide 6-21
Learning objective 3: Discuss allocation of

service department costs
Direct
Direct Method
Method of
of Allocating
Allocating
Service
Service Department
Department Costs
Costs
Service department costs allocated to production
departments but not to other service departments
Slide 6-22

Direct
Direct Method
Method
Mason
Mason Furniture
Furniture
Allocate janitorial cost of $100,000
Allocation base: square feet
Assembly Dept: 20,000 square feet
Finishing Dept: 30,000 square feet
Calculate Allocation Rate:

$100,000 / (20,000 + 30,000) = $2/sq ft
Allocation to Production Departments:

Assembly Dept.:20,000 sq ft x $2 = $40,000
Finishing Dept.: 30,000 sq ft x $2 = $60,000
Slide 6-23

Direct
Direct Method
Method
Mason
Mason Furniture
Furniture
Allocate personnel cost of $200,000
Allocation base: number of employees
Assembly Dept: 60 employees
Finishing Dept: 40 employees

$200,000 / (60 + 40) = $2,000/employee
Allocation to Production Departments

Assembly Dept: 60 x $2,000 = $120,000
Finishing Dept: 40 x $2,000 = $80,000
Slide 6-24

The direct method of allocating costs:

a. Allocates service department costs to other
service departments
b. Allocates only direct costs
c. Allocates service department costs to
production departments only
d. Both b and c
Answer:
c
Allocates service department costs to production
departments only
Slide 6-25
Learning objective 3: Discuss

allocation of service department costs
Direct
Direct Method
Method
Mason
Mason Furniture
Furniture
Slide 6-26

Three production departments:

- Showers
- Bathtubs
- Vanities
Two service departments:

- Mailroom
- Janitorial
Suggest allocation base for mailroom costs:

Number of employees, labor hours, or labor cost
Slide 6-27


- Showers
- Bathtubs
- Vanities
Two service departments:

- Mailroom
- Janitorial
Suggest allocation base for janitorial costs:
Square footage, number of work stations
Slide 6-28


- Showers: 80 employees
- Bathtubs: 40 employees
- Vanities: 30 employees
Allocate mailroom costs of $600,000 based on
employees
$600,000 / (80+40+30) = $4,000/employee
Allocation to Production Departments:
Showers: 80 x $4,000 = $320,000
Bathtubs: 40 x $4,000 = $160,000
Vanities: 30 x $4,000 = $120,000
Slide 6-29


- Showers: 1,500 sq ft
- Bathtubs: 1,000 sq ft
- Vanities: 500 sq ft
Allocate janitorial costs of $90,000 based on sq ft
$90,000 / (1,500+1,000+500) = $30 per sq ft
Allocate to production departments:
Showers : 1,500 x $30 = $45,000
Bathtubs: 1,000 x $30 = $30,000
Vanities : 500 x $30 = $15,000
Slide 6-30

Allocating
Allocating Budgeted
Budgeted and
and Actual
Actual
Service
Service Department
Department Costs
Costs
Management should allocate based on
budgeted costs rather than actual costs
Allocation of actual amounts allows service
department to pass on cost of inefficiencies
and waste to production departments
Slide 6-31

Problems
Problems with
with Cost
Cost Allocation
Allocation
Potential problems brought about by:
1. Allocations of costs that are not
controllable
2. Arbitrary allocations
3. Allocation of fixed costs that make the
fixed costs appear to be variable costs
4. Allocations of mfg. overhead to products
using too few overhead cost pools
5. Use of only volume related allocation bases
Slide 6-32
Learning objective 4: Identify potential

problems with cost allocation
Responsibility
Responsibility Accounting
Accounting and
and
Controllable
Controllable Costs
Costs
Responsibility accounting
Identifies those responsible for generating
revenue and controlling costs
Some cost allocations are not consistent

with responsibility accounting
- Controllable costs are those under the
managers control
- Some argue that managers should only be
allocated controllable costs
Slide 6-33

Arbitrary
Arbitrary Allocations
Allocations
Cost allocations are inherently arbitrary
Typically there are numerous allocation
bases that are equally justifiable
- Managers support the allocation which
makes them look best
- Managers reject allocations which cast an
unfavorable light on their performance
Slide 6-34

Unitized
Unitized Fixed
Fixed Costs
Costs and
and
Lump
Lump Sum
Sum Allocations
Allocations
Unitized fixed costs
- Fixed costs are stated on a per unit basis and
allocated as a variable cost
- Perception of costs as variable could alter
decision making
Lump-sum allocations
- Allocate predetermined amount of fixed costs
that is not affected by level of activity
- Allocation must appear to be fixed to
managers of departments receiving charge
Slide 6-35

When fixed costs are stated on a per unit

basis:
a. Fixed costs are said to be unitized
b. Fixed costs may appear to be variable to
managers receiving allocations
c. Decision making is greatly improved
d. Both a and b
Answer: d
Both a and b
Slide 6-36

Too
Too Few
Few Cost
Cost Pools
Pools
Although simple, may lead to distortion of
cost allocation, i.e. some products will be
overcosted or undercosted
Product costs will be more accurate when
more overhead cost pools are used
Must analyze cost-benefit relationship of
more cost pools
Slide 6-37

Problem
Problem of
of Using
Using Measures
Measures of
of Production
Production
Volume
Volume to
to Allocate
Allocate Overhead
Overhead
Typical allocation bases include direct
labor hours and machine hours
Assumes all overhead costs are
proportional to production volume
When OH costs not proportional to
production volume:
- High-volume products are overcosted
- Low-volume products are undercosted
Slide 6-38
Learning objective 5: Discuss activity-based

costing (ABC) and cost drivers
Using
Using Only
Only Volume-Related
Volume-Related
Allocation
Allocation Bases
Bases
Some firms allocate manufacturing
overhead based on volume, e.g. direct
labor or machine hours
Not all overhead costs vary with volume
Activity-based costing (ABC) solves this
problem
Slide 6-39

Activity-Based
Activity-Based Costing
Costing
Identifies major activities that cause
overhead costs to be incurred
Cost of resources consumed performing
these activities grouped into cost pools
Costs are assigned to products using a
measure of activity, i.e. cost driver
Slide 6-40

The
The ABC
ABC Approach
Approach
Slide 6-41

Common
Common Activities
Activities and
and
Associated
Associated Cost
Cost Drivers
Drivers
Slide 6-42

Activity
Activity Based
Based CostingCostingMcMaster
McMaster Screen
Screen Technologies
Technologies
Slide 6-43
Learning objective 5: Discuss activitybased costing (ABC) and cost drivers
Two cost pools used:

Equipment setups
- Total setups = 10,000
- Total cost = $1,500,000
Inspections
- Total inspections = $15,000
- Total cost = $3,000,000
Cost per equipment setup:

$1,500,000 / 10,000 = $150 per setup
Slide 6-44
Two cost pools used:

Equipment setups
- Total setups = 10,000
- Total cost = $1,500,000
Inspections
- Total inspections = 15,000
- Total cost = $3,000,000
Cost per inspection:

$3,000,000 / 15,000 = $200 per inspection
Slide 6-45
Allocation Rates:
Equipment setups = $150 per setup
Inspections = $200 per inspection
Product cost and activity:
Cost/Unit for Product EP150:
Slide 6-46
Allocation Rates:
Equipment setups = $150 per setup
Inspections = $200 per inspection
Product costs and activity:
Cost/unit for product EP175:
Slide 6-47
Benefits
Benefits of
of ABC
ABC
Provide more accurate costing
- Less likely to undercost/overcost due to cost
driver usage
May lead to improvements in cost control

- Costs broken out into a number of activities
rather than into one or two overhead cost
pools
Slide 6-48
Limitations
Limitations of
of ABC
ABC
More costly to develop and maintain than
a traditional costing system
Used to develops full cost of products
- Includes fixed costs
- Lacks incremental information
necessary for decision making
Slide 6-49
Fixed
Fixed and
and Variable
Variable Costs
Costs
Slide 6-50

Activity-Based
Activity-Based Management
Management
Activity analysis aimed at improving
efficiency and effectiveness of business
processes
ABC focus is on measuring cost of
products and services
ABM focus is on goal of managing the
activities themselves
Slide 6-51
Learning objective 6: Distinguish activity-based costing

(ABC) from activity-based management (ABM)
Activity-Based
Management
Slide 6-52

Activity-Based
Management
Determine major activities
Identify resources used by each
activity
Evaluate the performance of the
activities
Identify ways to improve the efficiency
and/or effectiveness of the activities
Slide 6-53

Cost
Cost Allocation
Allocation and
and Decision
Decision
Making
Making
Slide 6-54

Copyright
Copyright
2010 John Wiley & Sons, Inc. All rights
reserved. Reproduction or translation of this
work beyond that permitted in Section 117 of the
1976 United States Copyright Act without the
express written permission of the copyright
owner is unlawful. Request for further
information should be addressed to the
Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for
his/her own use only and not for distribution or
resale. The Publisher assumes no responsibility
for errors, omissions, or damages, caused by the
use of these programs or from the use of the
information contained herein.
Slide 6-55

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CHAPTER

Learning objective 1: Explain why indirect

Learning objective 1: Explain why indirect

Learning objective 1: Explain why indirect

Learning objective 1: Explain why indirect

Learning objective 1: Explain why indirect

Learning objective 1: Explain why indirect

Learning objective 1: Explain why indirect

Learning objective 2: Describe the

Learning objective 2: Describe the

Learning objective 2: Describe the

Learning objective 2: Describe the

In the cost allocation process, the cost

Learning objective 2: Describe the

Learning objective 2: Describe the

If indirect costs are fixed, cause-andeffect relationships are difficult to

Learning objective 2: Describe the

Learning objective 2: Describe the

Learning objective 2: Describe the

In the cost allocation process, an allocation

Learning objective 2: Describe the

Ability to bear costs

Equity approach to allocation

Learning objective 2: Describe the

Learning objective 3: Discuss allocation of

Learning objective 3: Discuss allocation of

Calculate Allocation Rate:

Allocation to Production Departments:

Learning objective 3: Discuss allocation of

Calculate Allocation Rate:

Allocation to Production Departments

Learning objective 3: Discuss allocation of

The direct method of allocating costs:

Learning objective 3: Discuss

Learning objective 3: Discuss allocation of

Three production departments:

Two service departments:

Suggest allocation base for mailroom costs:

Learning objective 3: Discuss allocation of

Three production departments:

Two service departments:

Learning objective 3: Discuss allocation of

Three production departments:

Learning objective 3: Discuss allocation of

Three production departments:

Learning objective 3: Discuss allocation of

Learning objective 3: Discuss allocation of

Learning objective 4: Identify potential

Some cost allocations are not consistent

Learning objective 4: Identify potential

Learning objective 4: Identify potential

Learning objective 4: Identify potential

When fixed costs are stated on a per unit

Learning objective 4: Identify potential

Learning objective 4: Identify potential

Learning objective 5: Discuss activity-based

Learning objective 4: Identify potential

Learning objective 5: Discuss activity-based

Learning objective 5: Discuss activity-based

Learning objective 5: Discuss activity-based

Learning objective 5: Discuss activitybased costing (ABC) and cost drivers

Two cost pools used:

Cost per equipment setup: