Chapter 6 cost allocation and activity based costing
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Chapter 6 Cost Allocation and Activity-Based Costing. Presentation Outline. Purposes of Cost Allocation The Process of Cost Allocation Activity Based Costing. I. Purposes of Cost Allocation. To Provide Information for Decision Making To Reduce Frivolous Use of Common Resources

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Chapter 6 Cost Allocation and Activity-Based Costing

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Chapter 6 cost allocation and activity based costing

Chapter 6Cost Allocation and Activity-Based Costing


Presentation outline

Presentation Outline

  • Purposes of Cost Allocation

  • The Process of Cost Allocation

  • Activity Based Costing


I purposes of cost allocation

I. Purposes of Cost Allocation

  • To Provide Information for Decision Making

  • To Reduce Frivolous Use of Common Resources

  • To Encourage Evaluation of Services

  • To Provide “Full” Cost Information


A to provide information for decision making

A. To Provide Information for Decision Making

From a decision making standpoint, the allocated cost should measure the opportunity cost of using a company resource.


B to reduce frivolous use of common costs

B. To Reduce Frivolous Use of Common Costs

By not allocating costs, resources may appear “free” to users. However, resources never come with zero costs.


C to encourage evaluation of services

C. To Encourage Evaluation of Services

Users of services should consider the possibility of lower cost alternative. This is unlikely to be considered if costs are not allocated to the user.


D to provide full cost information

D. To Provide “Full” Cost Information

  • GAAP requires full-costing for external reporting purposes.

  • In the long run, all costs must be covered.


Ii the process of cost allocation

II. The Process of Cost Allocation

  • The Steps of Cost Allocation

  • Arbitrary Approaches to Cost Allocation

  • Allocating Service Department Costs

  • Problems with Cost Allocation


A the steps of cost allocation

A. The Steps of Cost Allocation

  • Determine the Cost Objective (Cost Object).

  • Form Cost Pools

  • Select an Allocation Base to Relate the Cost Pools to Cost Objects


1 identifying the cost objective cost object

1. Identifying the Cost Objective (Cost Object)

Determine the product, service, department, etc., that is to receive the allocation.


2 form cost pools

2. Form Cost Pools

A cost pool is a grouping of individual costs, the sum of which is allocated using a single allocation base.

Cost pools include:

  • Departments (i.e., maintenance or personnel departments)

  • Major Activities (i.e., equipment setups)


3 select an allocation base to relate the cost pools to cost objects

3. Select an Allocation Base to Relate the Cost Pools to Cost Objects

  • It is very important that the allocation base relates the cost pool to the cost object.

  • Allocation should be based on a cause and effect relationship between costs and cost objects.

  • If cause and effect cannot be established, other approaches are used.


B arbitrary approaches to cost allocation

B. Arbitrary Approaches to Cost Allocation

  • Relative benefits approach – cost should be allocated in accordance with the cost objects that benefit the most from the cost.

  • Ability to bear costs – cost should be allocated to cost objects in proportion to profitability.

  • Equity approach – allocate costs in a method that is perceived to be fair and equitable.


C allocating service department costs

C. Allocating Service Department Costs

  • Manufacturing areas are often organized by (1) production departments directly involved in the manufacturing process, and (2) service departments that provide assistance to production departments.

  • In order to avoid passing on inefficient cost control of service departments to production departments, budgeted rather than actual service department costs should be allocated to production departments.

See illustration on pages 195-196


D problems with cost allocation

D. Problems with Cost Allocation

  • Managers may be evaluated on the basis of costs beyond their control.

  • Allocations of fixed costs make them appear as variable.

  • Use of only volume related allocation bases are inappropriate for costs that are not affected by volume. This can result in low volume items being undercosted, while high volume items are overcosted.


Iii activity based costing abc

III. Activity Based Costing (ABC)

  • The ABC Approach

  • Pros and Cons of ABC

  • Activity Based Management (ABM)

  • An Illustration of ABC


A the abc approach

A. The ABC Approach

  • Identify the major activities that cause overhead costs to be incurred.

  • Group costs of activities into cost pools.

  • Identify measures (allocation bases) of activities (the cost driver).

  • Relate costs to products using the cost drivers.


B pros and cons of abc

B. Pros and Cons of ABC

  • ABC is less likely than traditional costing to undercost or overcost products.

  • ABC may lead to improvements in cost control (thru ABM)

  • ABC can be expensive since data regarding numerous allocation bases must be collected.


C activity based management abm

C. Activity Based Management (ABM)

  • Determine major activities

  • Identify resources used by each activity

  • Evaluate the performance of the activity (benchmark against similar activities at other places)

  • Identify ways to improve the efficiency and/or effectiveness of the activities (compare to best practices at other places)


Chapter 6 cost allocation and activity based costing

D. An Illustration of ABC


Combining activity cost pools

Combining Activity Cost Pools

  • Unit-level activities – Performed each time a unit is produced. Example: Machine power.

  • Batch-level activities – Performed each time a batch is produced. Example: Setup costs.

  • Product-level activities – Relates to a certain product regardless of runs or batches. Example: Product design

  • Organization-sustaining activities – Activities independent of customers or products. Example: Providing a computer network.


A traditional overhead calculation

A Traditional Overhead Calculation

Gardenrite Co. manufactures 85,000 units of a Spade and 800 units of a Mower. The company currently uses direct-labor cost to assign overhead costs to products. The company estimates that it will incur $40,000,000 in manufacturing overhead and estimates that labor cost will be $8,000,000. Compute the predetermined overhead rate.

$40,000,000

$8,000,000

$5 per labor dollar

=


Chapter 6 cost allocation and activity based costing

Direct materials $1.80

Direct labor 1.08

Direct materials $60.00

Direct labor 15.00

A Spade uses $1.08 direct-labor cost per unit while a Mower uses $15.00 direct-labor cost per unit. Use the following information to compute each product’s total unit cost:

Spade

Mower

Mfg. Overhead

1.08 DL$ x $5 = 5.40

$8.28

Mfg. Overhead

15 DL$ x $5 = 75.00

$150.00


Chapter 6 cost allocation and activity based costing

Expand the number of indirect-cost pools until each of these pools is homogeneous.


Chapter 6 cost allocation and activity based costing

Identify the preferred cost-allocation base (cost driver) for each indirect cost pool.

Number of Setups

Number of Material Requisitions

Number of Machine Hours

Number of Workstations Used


The first stage allocation

The First Stage Allocation

Overall Overhead

Cost Pool

$40,000,000

Setup

Costs

$4,000,000

Material

Handling

$2,000,000

Equipment

Deprec.

$10,000,000

Other

$24,000,000


Manufacturing activities

Manufacturing Activities


The second stage allocation spades

The Second Stage Allocation - Spades

Machine

Setups

$4,000,000/

1,000 =

$4,000

Material

Req.

$2,000,000/

2,000 =

$1,000

Machine

Hours

$10,000,000/

20,000 =

$500

Work-

stations

$24,000,000/

3,000 =

$8,000

$4,000

x 2

$8,000

$1,000

x 3

$3,000

$500

x 40

$20,000

$8,000

x 1

$8,000

$39,000

$39,000 / 85,000 units = 0.46 per unit


The second stage allocation mowers

The Second Stage Allocation - Mowers

Machine

Setups

$4,000,000/

1,000 =

$4,000

Material

Req.

$2,000,000/

2,000 =

$1,000

Machine

Hours

$10,000,000/

20,000 =

$500

Work-

stations

$24,000,000/

3,000 =

$8,000

$4,000

x 5

$20,000

$1,000

x 50

$50,000

$500

x 100

$50,000

$8,000

x 15

$120,000

$240,000

$240,000 / 800 units = $300 per unit


Product unit cost comparison

Spade (85,000 units)

Direct materials $1.80

Direct labor 1.08

Mfg overhead 5.40

Unit cost $8.28

Mower (800 units)

Direct materials $ 60.00

Direct labor 15.00

Mfg overhead 75.00

Unit cost $150.00

Product Unit Cost Comparison

Traditional Costing

Activity-Based Costing

Spade (85,000 units)

Direct materials $1.80

Direct labor 1.08

Mfg overhead .46

Unit cost $3.34

Mower (800 units)

Direct materials $ 60.00

Direct labor 15.00

Mfg overhead 300.00

Unit cost $375.00


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