Chapter 6 Cost Allocation and Activity-Based Costing

Transcription

1 Chapter 6 Cost Allocation and Activity-Based Costing QUESTIONS 1. Indirect costs are allocated to (1) provide information for decision making, (2) reduce frivolous use of common resources, (3) encourage evaluation of internally provided services, and (4) calculate the full cost of products for GAAP reporting. 2. The statement is false. Cost allocation refers to the process of assigning indirect costs. Direct costs are traced to cost objects. Costs are allocated for a variety of reasons. It is not economically feasible to directly trace some costs to cost objects these costs are classified as indirect costs and are allocated to the cost object via the use of an allocation base. 3. Charging for internal services can reduce frivolous use of resources and encourage departments being charged to critically evaluate the service. In addition, GAAP requires that all manufacturing costs be assigned to goods being produced. Thus, cost allocation of indirect manufacturing costs is required. 4. Cost-plus contracts specify that the contractor will be paid for the cost of production (or services) plus some fixed amount or percentage of cost. Defense contracts with the federal government are often cost-plus contracts. A major problem with cost-plus contracts is that they give the contractor an incentive to allocate as much cost as possible to the cost-plus contract (via the choice of an allocation base) where it will be reimbursed. 5. A cost objective is a product, service, or department that receives an allocation of cost. For example, a production department that receives an allocation of janitorial cost is a cost objective. Likewise, a product in a department that receives an allocation of depreciation of equipment is a cost objective. 6. A cost pool is a collection of individual indirect costs whose total is allocated using one allocation base. Cost pools are often formed along department lines. For example, the maintenance cost pool would include all costs of the maintenance department. 7. A concern in forming a cost pool is that the costs within the cost pool be similar or homogeneous. It is unlikely that variable and fixed costs are similar (i.e., that one allocation base is suitable for allocating both fixed and variable costs). Homogeneous cost pools provide more accurate information.

2 6-2 Jiambalvo Managerial Accounting 8. Number of employees in a department would, most likely, result in a cause-and-effect allocation (at least for the variable costs in the cafeteria). 9. (1) Benefits received (relative benefits) (2) Ability to bear costs (3) Equity or fairness 10. If budgeted costs are allocated, then service departments cannot pass on inefficiencies and waste. Allocating actual costs gives the service department little incentive to be efficient. 11. In a responsibility accounting system, revenues and costs are traced to departments/ divisions and individuals with related responsibility for generating revenues and controlling costs. This facilitates performance evaluation of managers and the operations under their control. 12. Sometimes managers are allocated costs beyond their control in order to make them aware that the cost exist and must be covered by revenues of the firm. 13. Unitizing fixed costs make them appear to be variable. If the unitized fixed costs are then allocated to divisions based on, for example, revenue, divisional managers may make decisions in order to maximize divisional profits that are not in the company s best interest. This problem can be avoided by lump-sum allocations of fixed costs. 14. Traditional allocation methods use a small number of cost pools and allocation bases related to production volume. However, some costly activities are not related to production volume. Consider the costs associated with setups in a traditional costing system setup costs would be allocated based on production volume and high volume products will receive most of the allocated cost even though low volume products may require an equal number of setups. 15. The traditional costing approach typically uses allocation bases that are measures of production volume (e.g., direct labor hours, direct labor cost, or machine hours). Also, few cost pools are used under the traditional approach (e.g., one or two cost pools). ABC focuses on major activities that cause overhead costs to be incurred. Many of these activities are not related to production volume. Cost pools are formed for each major activity and costs are assigned to products using an allocation base that is a cost driver. Many of the cost drivers are not related to production volume. ABC typically uses more cost pools and related cost drivers.

3 Chapter 6 Cost Allocation and Activity-Based Costing ABC will tend to give more accurate costs than a traditional cost system when: (1) the production process is complex and varied (high and low volume products), (2) products consume resources differently, and (3) there are activities that are not related to production volume (e.g., setups). 17. (1) ABC is more costly to develop and maintain than a traditional system. (2) In practice, ABC is used to develop the full cost of products. The ABC cost per unit does not measure the incremental costs needed to produce an item. Therefore, it is not always useful for decision making. 18. ABC focuses on activities with the goal of measuring costs of products and services produced by the firm. ABM focuses on activities with the goal of managing the activities themselves. ABC has the goal of accurately computing costs of products and services while ABM focuses on reducing the costs of or the demand for major activities.

4 6-4 Jiambalvo Managerial Accounting EXERCISES E1. Fixed costs (e.g., administrative costs) are sometimes allocated based on a measure of business activity (e.g., sales). This makes the costs appear to be variable (e.g., the higher sales, the higher the allocation of administrative cost). In turn, this may lead to poor decisions if managers treat the allocated costs as incremental. E2. This allocation is potentially harmful. A hotel manager will tend to overestimate the costs that increase with revenue. And this may lead to poor decisions that affect revenue. For example, suppose a hotel manager is considering a trade association s request for a special convention rate of $70 per room during a slow season. The manager estimates that variable costs per room are $75 including $10 of allocated costs for general administration. In this case, the manager will turn down the request even though his or her company would really make $5 of incremental profit per room. Remember, $10 of allocated costs appear variable but, in fact, are fixed. Thus, actual incremental costs are only $65, which is $5 less than incremental revenue of $70. E3. According to Table 1 displayed at this Web site, building depreciation is allocated based on square footage, telecommunications costs are allocated based on number of phone numbers (referred to as direct telephone ID), and administrative and general costs are allocated based on a unit s total expense as a percent of the total expense of all units. These allocations are not cause and effect allocations. Consider building depreciation. When a unit occupies space, it doesn t cause cost equal to allocated depreciation. It may be that the space wasn t occupied, in which case no cost was caused. Or, occupancy may have led to a need to rent additional space, causing a cost much higher than allocated depreciation. Rather, the allocations are based on relative benefit. Thus, for example, if you occupied space you benefited! And the assumption is that your benefit was proportionate to space occupied. E4. Star might want to encourage department managers to evaluate security services. When security costs are allocated, departments have an incentive to

5 Chapter 6 Cost Allocation and Activity-Based Costing 6-5 voice concerns about the cost of security service. This may make the security department more efficient. In addition, allocation of security costs that relate to manufacturing are required under GAAP. E5. a. Service Department Allocation Base Human resources Number of employees Duplicating Number of pages copied Janitorial Floor space Accounting Number of sales transactions Graphic design Time spent on design work Food services Number of employees b. Under the direct method costs are not allocated between service departments. Thus, the Human Resource department would not receive a share of Food Services costs. E6. Total fixed costs to be allocated = $60, , , ,000 = $92,000. Fixed costs allocated to Sales ($92,000.3) $ 27,600 Variable costs allocated to Sales (1,500,000 copies $.02) 30,000 Total costs allocated to Sales $ 57,600 Fixed costs allocated to Admin. ($92,000.7) $ 64,400 Variable costs allocated to Admin (2,500,000 copies $.02) 50,000 Total costs allocated to Sales $114,400 E7. Allocation Base Prod. Dept.1 Prod. Dept.2 Square footage $1,200,000 $1,800,000 Direct labor hrs. $1,800,000 $1,200,000 (1) As indicated, the choice of the allocation base greatly affects the allocations of cost. Use of square footage as the allocation base assigns 60% of the cost to department 2 and 40% to department 1. However, use of direct labor hours allocates 60% of the cost to department 1 and only 40% to

6 6-6 Jiambalvo Managerial Accounting department 2. Department 1 would prefer to be allocated cost based on square footage and department 2 would prefer direct labor hours as the base. (2) An allocation base that results in a cause and effect allocation is preferred. If maintenance costs are mostly related to building maintenance, then square footage is more likely to result in a cause and effect allocation. However, if maintenance costs are mostly made up of machine maintenance, then machine hours might be a better allocation base. E8. P1 has 150/375 = 40% of production department employees. P2 has 225/375 = 60% of production department employees. Service Service dept. Cost Allocated to Department Costs P1 P2 S1 $3,000,000 $1,200,000 $1,800,000 S2 2,000, ,000 1,200,000 S3 Total cost 1,000,000 $6,000, ,000 $2,400, ,000 $3,600,000 E9. a. The manufacturing overhead allocation includes $52 of fixed cost which will not increase if the special order is accepted (i.e., it is not an incremental cost). The incremental revenue and incremental costs associated with the order suggests that the company will be better off by $45,000 if the order is accepted. Incremental revenue (1,000 $175) $175,000 Incremental costs Material (1,000 $80) 80,000 Labor (1,000 $40) 40,000 Variable overhead (($1,000 $10) 10, ,000 Incremental profit $ 45,000 b. Managers who focus on reported cost may (incorrectly) treat the $52 of fixed cost as an incremental cost. In this case they will (incorrectly) conclude that the order should not be accepted because the total cost ($182) is greater than the offer ($175).

7 Chapter 6 Cost Allocation and Activity-Based Costing 6-7 E10. a. The reason that allocated general and administrative costs are higher for the Services Department is that revenue in the Sales Department has decreased. Since general and administrative costs are allocated based on actual revenues, changes in one department s revenue affects another department s allocation of overhead costs (since it has a higher proportion of total revenue). b. If accounting department costs are affected by Rex Kerr s decisions, then he should be held responsible for those costs. However, it appears that his department is being allocated costs over which he has no control. Allocating cost beyond Kerr s control may cause him to feel that he has been treated unfairly, especially if his performance is based on the service department s profits. E11. a. The manager of Keller Auto Insurance will perceive that allocated service department costs are variable cost (when auto insurance revenue increases, the allocated costs increase). b. In performing incremental analysis, the president of Keller Auto Insurance will tend to overestimate incremental costs because he or she will treat allocated costs as incremental costs (when some of the costs are, in all likelihood, fixed).

8 6-8 Jiambalvo Managerial Accounting E12.a. The use of a single cost pool causes A1 to be undercosted and B1 to be overcosted. With a single cost pool, both products receive the same allocation of cost per labor hour. However, A1 uses relatively more time in P1 where overhead costs are high while B1 uses relatively more time in P2 where overhead costs are low. The one-cost pool overhead rate is: $3,000, ,000 DLH = $7.50 /DLH Each product requires 5 direct labor hours in total. Therefore, each will be allocated $37.50 in overhead costs ($7.50 5) Now let s calculate the amount of overhead allocated to each product if Mott used a separate overhead cost pool for each production department. P1 s overhead rate will be $2,000, ,000 DLH = $20.00 per direct labor hour. P2 s overhead rate will be $1,000, ,000 DLH = $3.33 per direct labor hour. Overhead allocated to each unit of A1 will be: (2 labor hours $20) + (3 labor hours $3.33) $49.99 Overhead allocated to each unit of B1 will be: (1 labor hour $20) + (4 labor hours $3.33) $33.32 Note that the overhead allocated to B1 is lower with two cost pools while the allocation to A1 is higher. E13. a. If the costs of the design department are fixed and the department is able to complete jobs on a timely basis, then the opportunity cost of using the department is approximately zero and equal to the allocation (which is also zero). b. Subsidiaries often have to go outside for design work because of time delays. Thus, there is an opportunity cost associated with use that is greater than the allocation (which is zero). c. The allocation of $50 per hour must be less than the opportunity cost (subsidiaries are willing to pay $70 per hour to avoid delays). Thus, they must have a benefit that exceeds $70.

9 Chapter 6 Cost Allocation and Activity-Based Costing 6-9 d. The opportunity cost of using design services may be less than $50 since no one is being turned away or delayed. Thus, there does not appear to be a benefit foregone because of use. E14. COST POOL COST DRIVER Inspection of raw materials Number of receipts Production equipment repairs and maintenance Machine hours Raw materials storage Dollar value of raw materials Plant heat, light, water, and power Square footage Finished product quality control Number of inspections Production line setups Number of setups E15. Cost per setup = $1,500,000 1,000 = $1,500 Cost of setups related to EP150 = 2 $1,500 = $3,000 Setup cost per unit of EP150 = $3, = $4 E16. If the cost to process an order is much higher at one plant than at the other and the orders are similar, then there is a good chance that the costs are out of control at the higher cost location and a manager should investigate the situation. Conceivably, the company can adopt best practices from the low cost plant. E17. a. The cost of filling orders at PorcheParts.com is: ($250,000 + $300,000) 100,000 = $5.50 per order. The cost of filling orders at the auto supply chain is only $4 per hour. While this is lower, it may be that that, due to its size, the auto supply chain has a state of the art warehouse. It may be unrealistic for PorcheParts.com, which is relatively small, to compare itself to such a large company. b. Possibly, order pickers can take multiple order sheets out to the warehouse when individual orders are small. This will save considerable time going back and forth to the warehouse and may lead to lower costs if the company is willing to fire or reassign one or more of the five workers who pick parts.

10 6-10 Jiambalvo Managerial Accounting PROBLEMS P1. a. Allocation Base Software Consulting Employee benefits Head count Proportion Amount allocated $1,000,000 $750,000 $250,000 Rent Square feet 15,000 15,000 Proportion.5.5 Amount allocated $600,000 $300,000 $300,000 Telecommunications Headcount Proportion Amount allocated $400,000 $300,000 $100,000 General and adm. costs Sales $10,000,000 $5,000,000 Proportion Amount allocated Total $2,000,000 $4,000,000 $ 1,333,334 $ 2,683,334 $ 666,666 $1,316,666 Profit Report: (using multiple cost pools/allocation bases) Software Consulting Sales $10,000,000 $5,000,000 Less direct costs 5,000,000 3,000,000 Less allocated costs Income before taxes 2,683,334 $ 2,316,666 1,316,666 $ 683,334 Using multiple cost pools and multiple allocation bases allocates $316,666 more overhead cost to consulting than a single allocation base method. b. Assuming the controller s assumptions are correct (that benefits and telecommunications costs are driven by headcount while rent is driven by space occupied and general and administrative costs are driven by relative sales), then the multiple cost pools provide better information on the resources consumed and the profitability of the two divisions.

11 Chapter 6 Cost Allocation and Activity-Based Costing 6-11 P2. a. The opportunity cost of producing a Model 350 motor is simply the incremental cost of production (given that Binder has excess capacity and sales to Dacon will not affect sales to other customers). Direct material $20 Direct labor 10 Variable overhead ($.80 direct labor)* 8 Total $38 * Variable overhead rate is equal to $4,000,000 of variable overhead $5,000,000 of direct labor. b. Since 60 percent of the overhead is fixed ($12 per motor), the incremental cost to produce the motors is $38 per motor ($ ). Any bid greater than $38 (that s accepted) will generate incremental profit. If Binder can get the order with a bid of $48, the company should bid this amount. It will generate incremental profit of $50,000 [($48 - $38) 5,000 motors]. c. The opportunity cost related to overhead, in this case, is simply the variable overhead amount. An allocation based on the opportunity cost idea, helps managers focus on incremental costs the information needed for decision making.

12 6-12 Jiambalvo Managerial Accounting P3. a. Overhead rate based on direct-labor dollars ($50,000,000 overhead $5,000,000 labor) $10 per dollar of labor Overhead rate based on machine hours ($50,000,000 overhead 500,000 machine hours) $100 per machine hour Civilian Military Labor$ Mach.Hrs. Labor$ Mach.Hrs. Direct material $2,000 $ 2,000 $ 2,500 $ 2,500 Direct labor Overhead Cost 6,000 $8,600 8,000 $10,600 9,000 $12,400 8,000 $11,400 b. The price charged for the civilian version of the Model KV10 does not depend on allocated costs. However, the military version is sold for cost plus 10 percent of cost. Therefore, the company has an incentive to make cost appear higher rather than lower. This can be accomplished by allocating overhead cost using direct labor cost as the allocation base. This base results in a higher cost ($12,400) compared to an allocation based on machine hours which results in a cost of only $11,400. c. Many, if not most, managers believe that it is well known that allocation is somewhat arbitrary and the government is not at all surprised that companies pick allocation bases to maximize their profit. Since no one is being fooled, the behavior is not illegal, and the right allocation isn t obvious, picking an allocation base to maximize profit does not appear to be unethical.

13 Chapter 6 Cost Allocation and Activity-Based Costing 6-13 P4. a. Twenty percent of air miles are by Domestic (5,000,000 miles 25,000,000 miles) and International flights accounts for 80 percent of the total air miles. Therefore, Domestic flights will be allocated 20 percent of the service departments costs and International will be allocated 80 percent. Allocated to Costs Domestic International Ticketing $ 4,000,000 $ 800,000 $3,200,000 Baggage handling 2,000, ,000 1,600,000 Maintenance Total 6,000,000 $12,000,000 1,200,000 $2,400,000 4,800,000 $9,600,000 b. The best cause-and-effect relation is probably between maintenance costs and air miles flown (the most suspect relation is between ticketing and air miles flown more miles do not lead to higher ticketing costs). Given that international passengers have more baggage and have more transfers than domestic flyers, the relation between baggage handling costs and air miles flown is probably stronger than the relation between air miles and ticketing but weaker than the relation between air miles and maintenance. A better allocation base for ticketing might be number of tickets issued. A better allocation base for baggage handling might be number of bags handled. P5. Production department use of service Service depts. Assembly Testing Maintenance ($400,000) 70% 30% Computing ($600,000) 33.33% 66.67% Service dept. costs allocated to Assembly: (.7 $400,000) + (.3333 $600,000) = $280, ,000 = $480,000. Service dept. costs allocated to Testing: (.3 $400,000) + (.6667 $600,000) = $120, ,000 = $520,000.

14 6-14 Jiambalvo Managerial Accounting P6. a. Allocation Base Financial Planning Business Consulting Proportion Amount Proportion Amount Salaries.667 $666, $333,333 Headcount.750 $750, $250,000 b. Both headcount and salary appear to be plausible allocation bases, but they result in very different allocations. This suggests that in many cases allocations are somewhat arbitrary. P7. a. Old overhead rate $10 per labor hour Current overhead rate ($2,400, ,000 direct labor hours) $16 per labor hour Current overhead cost allocated to an 8 labor-hour job: ($16 8 labor hours) $128 Prior year overhead allocated to an 8 labor-hour job ($10 8 labor hours) $80 The current overhead cost for an 8 labor-hour job is 60% more than the prior overhead cost. b. Small jobs in the current year appear to be less profitable compared to the prior year. This is because they are allocated overhead costs as if they required use of the new equipment. Therefore, small jobs will be overcosted. In all likelihood, the jobs do not really cost more than they did in the prior year. One way to avoid miscosting of small (labor-intensive) jobs would be to develop a separate overhead allocation rate for jobs that are labor intensive and do not make use of the new equipment.

15 Chapter 6 Cost Allocation and Activity-Based Costing 6-15 P8. a. The recreation kayaks are uniform and probably made in large batches. The competition kayaks are custom made one at a time. Several costs in the overhead cost pool are probably less expensive on a per unit bases for recreation versus competition kayaks. For example, each competition kayak probably requires (on average) more equipment time, quality control, and setup and drafting costs compared to each recreation kayak. b. Summit needs to look at the costs of activities that each line of kayaks requires. Summit could get more accurate costs if each of the major overhead cost components were allocated to the kayak line using an appropriate cost driver. c. Cost Pool Cost Recreation Competition use of base allocation use of base allocation Building $ 25, $ 21, $ 3,571 Equipment 25, , ,750 Materials ordering 15, , ,000 Quality control 10, , ,333 Maintenance & security 10, , ,429 Set up and drafting 20, , ,333 Supervision Total 30,000 $135, ,000 $101, ,000 $33,416 Per kayak $ $ Total unit costs for each model boat: Recreation Competition Direct materials $ Direct labor Overhead Total unit cost Sales price Gross Profit $ $ 25.84

16 6-16 Jiambalvo Managerial Accounting d. The traditional allocation method used by Summit is essentially a volumebased method. In this problem, each unit of the competition kayak used the same amount of direct labor as a recreation kayak, but required much more of some overhead resources. For example, total competition kayaks accounted for 10 percent of volume and required 10 percent of direct labor but needed 66.7 percent of set up and drafting resources. Using a single traditional allocation base assumes that each product uses all overhead resources in the same proportion that the allocation base is used. Except for supervision, competition kayaks use more than 10 percent of overhead resources. Better information will be provided by an ABC system. With an ABC system, cost pools will be formed for key activities and overhead drivers (allocation bases) need not be based on production volume. P9. a. Cost Pool Materials ordering Materials inspection Equipment setup Quality control Other Overhead rate $800, ,000 = $8.00 / order $400,000 2,000 = $200 / rec. report $2,000, = $20,000 / setup $900,000 4,000 = $225 / inspection $15,000,000 $10,000,000 = $1.50 / labor cost b. Materials ordering $8.00 per order 1,000 orders = $ 8,000 Materials inspection $200 per report 300 reports = 60,000 Equipment setup $20,000 per setup 1 setups = 20,000 Quality control $225 per inspection 400 inspections = 90,000 Other $1.50 per labor dollar $120,000 = 180,000 Total overhead assigned to Remote Mouse $358,000 c. Overhead rate per unit of Remote Mouse = $358,000 20,000 units = $17.90 d. Total unit costs per unit of Remote Mouse = $31 + $6 + $17.90 = $54.90 e. With a traditional system: The overhead rate per direct labor dollar is: ($19,100,000 $10,000,000 direct labor cost) $1.91 per dollar of direct labor

17 Chapter 6 Cost Allocation and Activity-Based Costing 6-17 The direct labor cost, per unit, for the Remote Mouse: ($120,000 20,000 units) $6.00 Overhead assigned to each unit of Remote Mouse ($1.91 $6.00 direct labor cost) $11.46 ABC assigns $6.44 more overhead to each unit of Remote Mouse than is assigned using a traditional production volume base. Remote Mouse production uses only 1.2 percent of direct labor dollars, but requires 10 percent of materials ordering, 15 percent of materials inspection, and 10 percent of quality control resources. Remote Mouse production uses a relatively a small amount of direct labor dollars and is therefore undercosted a traditional approach to allocation. P10. a. Cost to book travel (per completed trip): $800,000 20,000 completed trips = $40 per completed trip The benchmark cost is $30 per completed trip. Thus, it appears that Baxter s costs are relatively high (33% more than the benchmark), and process improvement is warranted. b. The wages paid to employees who book travel are $630,000 (14 employees $45,000. Number of completed trips booked: 1,000 consultants 20 trips 20,000 trips Number of trips booked but not necessarily completed: ,000 26,000 trips Bookings not completed 6,000 trips Wage cost per trip booked but not necessarily completed: $630,000 26,000 $24.23 Wage cost of trips not completed: 6,000 $24.23 $145, Savings if number can be reduced by 50 percent: $145,380.5 $72,690.00

18 6-18 Jiambalvo Managerial Accounting P11. a. A sophisticated Web site and call center can reduce demands placed on tellers to process deposits, process withdrawals, deal with requests for CDs, answer questions related to balances, and respond to requests for statements. A sophisticated Web site or call center will not impact teller time to provide access to safe deposit boxes or reconcile the cash drawer. b. A sophisticated Web site, automatic cash machines, and call center software that provides responses to common questions are examples of technology that can reduce the cost of services provided by tellers. P12. With 6,000 employees and turnover of 15%, 900 people leave the company and 900 are added to take their place each year (.15 x 6,000). With this in mind, having 6 employees to handle new employee training appears excessive. Suppose each new employee requires a half day of training. That implies 450 training days. Assume that each trainer works 5 days per week for 48 weeks per year. Then, each trainer covers 240 training days. Thus, only 2 trainers are needed ( = 1.875). Reducing trainers by 4 would save $20,000 in salary each month. Now, consider operations. It s not clear that 5 clerks are needed. Suppose paperwork related to resignations and new hires is 2 hours per person. This implies a need for 3,600 hours (2 hours x 1,800 resignations or hires). Assuming each clerk works 8 hours per day, with a 5 day work week for 48 weeks, a clerk has 1,920 hours. Again, it appears that only 2 clerks are needed (3,600 1,920 = 1.875). A reduction of 3 clerks would save $7,500 per month. Based on the above analysis, which admittedly required some ballpark assumptions, the low hanging fruit is in operations and training. Note that the total savings is estimated to be $27,500 per month or $330,000 per year. Assuming the ABM study reduced waste for 3 years, the company would save approximately $1,000,000. If similar savings could be found in other departments, ABM would create substantial shareholder value.