Cost Allocation and Activity-Based Costing

1. 0 26 Cost Allocation and Activity-Based Costing

2. 0 26-1 Objective 1 Identify three methods used for allocating factory overhead costs to products.

3. 0 Product Costing 26-1 Most companies have accounting systems that trace revenues to individual product lines. In addition, they need to subtract the cost of manufacturing their product from revenues in order to determine the profit from sales. Determining the cost of the product is termed product costing.

4. Single Rate Department Department Activity Activity 0 Factory Overhead Allocation Methods 26-1 P R O D U C T S Plantwide Overhead Rate Multiple Department Rates Activity-Based Costing 4

5. 0 26-2 Objective 2 Use a single plantwide factory overhead rate for product costing.

6. 0 Single Factory Overhead Rate Method 26-2 Under the single plantwide factory overhead rate method, all of the factory overhead is allocated to all products, using only one rate.

7. 0 Ruiz Company Illustration 26-2 Ruiz Company manufactures two products, snowmobiles and lawnmowers. Both products are manufactured in a single factory. There is $1,600,000 of factory overhead budgeted for the period.

8. 0 26-2 Ruiz Company plans to manufacture 1,000 units of each product. Assume snowmobiles and lawnmowers both require 10 direct labor hours per unit to manufacture.

9. $1,600,000 20,000 direct labor hours $80 per direct labor hour = (1,000 x 10 dlh) + (1,000 x 10 dlh) 0 Computing Single Plantwide Factory Overhead 26-2 Total budgeted factory overhead costs Total budgeted plantwide allocation base 9

10. $1,600,000 20,000 direct labor hours $80 per hour overhead rate = 0 26-2 Snowmobile: $80 per dlh x 10 direct labor hours = $800 Lawnmower: $80 per dlh x 10 direct labor hours = $800 Factory Overhead Cost per Unit 10

11. 0 Single Plantwide Factory Overhead Rate Method—Ruiz Company 26-2 11

12. 0 26-2 The greatest advantage of the single plantwide overhead rate method is that it is simple and inexpensive to apply in practice.

13. 0 26-3 Objective 3 Use multiple production department factory overhead rates for product costing.

14. 0 26-3 Multiple Production Department Factory Overhead Rate Method The multiple production department factory overhead rate method uses different rates for each production department to allocate factory overhead to products.

15. 0 26-3 Comparison of Single Plantwide Rate and Multiple Production Department Rate Methods 15

16. $1,030,000 10,000 direct labor hours = $103 per dlh Assembly Department Overhead Rate: $570,000 10,000 direct labor hours = $57 per dlh 0 26-3 Production Department Factory Overhead Rates and Allocation Fabrication Department Overhead Rate: 16

17. 0 26-3 Allocating Factory Overhead to Products—Ruiz Company 17

18. 4 0 26-3 Multiple Production Department Rate Method—Ruiz Company 18

19. 0 26-3 Distortion in Product Costs—Single Plantwide versus Multiple Production Department Factory Overhead Rates Factory Overhead Cost per Unit Multiple Production Department Rates Single Plantwide Rate Snowmobile $800 $938 Lawnmower 800 662 19

20. and (Continued) 0 26-3 In general, the following conditions may indicate that a single plantwide factory overhead rate will lead to distorted product costs. Condition 1: Differences in production department factory overhead rates. There are significant differences in the factory overhead rates across different production departments. That is, some departments have high rates, while others have low rates

21. 0 26-3 Condition 2: Differences in the ratios of allocation-base usage. The products require different ratios of allocation base-usage across the departments. (Concluded)

22. 0 26-3 Conditions for Product Cost Distortion—Ruiz Company 22

23. 0 26-4 Objective 4 Use activity-based costing for product costing.

24. 0 26-4 Activity-Based Costing (ABC) Method The activity-based costing (ABC) methodallocates factory overhead more accurately than does the multiple production department rate method.

25. 0 26-4 Activity Cost Pools The activity-based costingmethoduses cost of activities to determine product costs. Under this method, factory overhead costs are initially accounted for in activity cost pools.

26. 0 26-4 Multiple-Production Department Factory Overhead Rate Method vs. Activity-Based Costing 26 (Continued)

27. 0 26-4 Multiple-Production Department Factory Overhead Rate Method vs. Activity-Based Costing 27 (Concluded)

28. 0 26-4 Ruiz Company Example Activity Cost Pool Amount Fabrication $ 530,000 Assembly 70,000 Setup 480,000 Quality control inspection 312,000 Engineering changes 208,000 Total budgeted factory overhead $1,600,000 28

29. 0 26-4 Activity Rates The activity cost pools are assigned to products, using factory overhead rates for each activity. These rates are often called activity rates.

30. 0 26-4 Activity Base Activity rates are determined by dividing the cost budgeted for each activity pool by the estimate activity base. This base is related to an activity pool.

31. 0 26-4 Estimated Activity-Base Usage Quantities—Ruiz Company 31

32. 0 26-4 Ruiz Company Estimated Budgeted Activity Amount Activity Rate Fabrication $ 530,000 / 10,000 dlh = $ 53 Assembly 70,000 / 10,000 dlh = $ 7 Setup 480,000 / 120 setups = $ 4,000 Quality control inspections 312,000 / 104 inspects. = $ 3,000 Engineering changes 208,000 / 16 changes = $13,000 Total $1,600,000 Cost Drivers 32

33. Fabrication: DL Hours Rate Total Snowmobile 8,000 $53 $424,000 Lawnmower 2,000 53 106,000 Total 10,000 $530,000 0 26-4 Budgeted Estimated Activity Amount Activity Rate Fabrication $ 530,000 / 10,000 dlh = $ 53 Assembly 70,000 / 10,000 dlh = $ 7 Setup 480,000 / 120 setups = $ 4,000 Quality control 312,000 / 104 inspts. = $ 3,000 Engineering 208,000 / 16 changes = $13,000 Total $1,600,000 33

34. Assembly: DL Hours Rate Total Snowmobile 2,000 $7 $14,000 Lawnmower 8,000 7 56,000 Total 10,000 $70,000 0 26-4 Budgeted Estimated Activity Amount Activity Rate Fabrication $ 530,000 / 10,000 dlh = $ 53 Assembly 70,000 / 10,000 dlh = $ 7 Setup 480,000 / 120 setups = $ 4,000 Quality control 312,000 / 104 inspts. = $ 3,000 Engineering 208,000 / 16 changes = $13,000 Total $1,600,000 34

35. Setup: Setups Rate Total Snowmobile 100 $4,000 $400,000 Lawnmower 20 4,000 80,000 Total 120 $480,000 0 26-4 Budgeted Estimated Activity Amount Activity Rate Fabrication $ 530,000 / 10,000 dlh = $ 53 Assembly 70,000 / 10,000 dlh = $ 7 Setup 480,000 / 120 setups = $ 4,000 Quality control 312,000 / 104 inspts. = $ 3,000 Engineering 208,000 / 16 changes = $13,000 Total $1,600,000 35

36. Quality Control: Inspts. Rate Total Snowmobile 100 $3,000 $300,000 Lawnmower 4 3,000 12,000 Total 104 $312,000 0 26-4 Budgeted Estimated Activity Amount Activity Rate Fabrication $ 530,000 / 10,000 dlh = $ 53 Assembly 70,000 / 10,000 dlh = $ 7 Setup 480,000 / 120 setups = $ 4,000 Quality control 312,000 / 104 inspts. = $ 3,000 Engineering 208,000 / 16 changes = $13,000 Total $1,600,000 36

37. Engineering: Changes Rate Total Snowmobile 12 $13,000 $156,000 Lawnmower 4 13,000 52,000 Total 16 $208,000 0 26-4 Budgeted Estimated Activity Amount Activity Rate Fabrication $ 530,000 / 10,000 dlh = $ 53 Assembly 70,000 / 10,000 dlh = $ 7 Setup 480,000 / 120 setups = $ 4,000 Quality control 312,000 / 104 inspts. = $ 3,000 Engineering 208,000 / 16 changes = $13,000 Total $1,600,000 37

38. 0 26-4 Cost Allocation Summary: Activity Snowmobile Mower Total Fabrication $ 424,000 $106,000 $ 530,000 Assembly 14,000 56,000 70,000 Setup 400,000 80,000 480,000 Quality control 300,000 12,000 312,000 Engineering 156,000 52,000 208,000 Total $1,294,000 $306,000 $1,600,000 Budgeted units 1,000 1,000 Cost per unit $1,294 $306 38

39. 0 26-4 Activity-Based Costing Method—Ruiz Company 39

40. 0 26-4 Distortion in Product Costs—Multiple Production Department Factory Overhead Rate Method versus Activity-Based Costing Factory Overhead Cost per Unit— Three Cost Allocation Methods Single Plantwide Multiple Production Rate Department Rates ABC Snowmobile $ 800 $ 938 $1,294 Lawnmower 800 662 306 40

41. 0 26-5 Objective 5 Use activity-based costing to allocate selling and administrative expenses to products

42. 0 26-5 Abacus Company Example The selling and administrative expenses of Abacus Company are allocated to its two products, Ipso and Facto, on the basis of warranty claims. Abacus Company has a budgeted cost of $150,000. One hundred warranty claims are estimated for the period.

43. Field Service Activity Cost Cost per Warranty Claim = Number of Claims $150,000 100 Cost per Warranty Claim = Cost per Warranty Claim $1,500 = 0 26-5 43

44. 0 26-5 Ipso had 10 warranty claims and Facto had 90 warranty claims. The field service activity would be allocated as follows: Ipso: 10 warranty claims x $1,500 per warranty claim = $15,000 Facto: 90 warranty claims x $1,500 per warranty claim = $135,000 44

45. 0 26-6 Objective 6 Use activity-based costing in a service business.

46. 0 Hopewell Hospital Example 26-6 Service businesses can use an activity-based costing system to determine how overhead is allocated to customers. The activity rate would be determined by dividing the budgeted activity cost pool by the estimated activity-base quantity, just as in a manufacturing firm.