Management Accounting: Cost Assignment

• Management Accounting, Section 3, Cost Assignment 1/2 for Bachelor in International Business

Learning Objectives

• Distinguish between cause-and-effect and arbitrary cost allocations
• Describe how cost systems differ in terms of sophistication level
• Differentiate and define cost tracing versus allocation
• Define and build the value chain.
• Define department centers and cost drivers.
• Distinguish operational departments from service departments
• Describe the four steps of the department traditional method.
• Construct an overhead analysis sheet and calculate cost driver rates.

Session 3 and 4 Topics

• Recap from Session 1
• Direct versus indirect costs (overheads)
• Cost assignment method
• Full cost
• Allocation costing system
• Cost driver and rate
• Blanket rate
• Department / traditional costing system topics
• Value chain and inventories
• Department definition
• Overhead allocation to cost objects
• Department cost driver rate
• Calculating the cost of cost objects:
• Purchasing cost of materials bought
• Inventory valuation: purchasing cost of materials consumed
• Production cost of finished goods made
• Inventory valuation: production cost of finished goods sold
• Full cost
• Profit and Loss
• Comparison between blanket rate and traditional method
• Conclusion

Recap of Direct vs. Indirect Costs

• Direct costs can be specifically and exclusively identified with a given cost object, such as materials and labor, and are directly traced to cost objects.
• Indirect costs, also known as overheads, cannot be specifically and exclusively identified with a given cost object, such as rent, electricity, and plant depreciation.
• Overheads are assigned to cost objects based on cost allocations.
• Direct and indirect costs are used to determine the cost of products.
• D&W produces doors and windows in the same plant, doors are made with wood, and windows are made with wood and glass.
• Glass melting machine depreciation, wood used to produce doors, transport fees of materials, plant heating are all examples of overhead.
• Wages paid to workers are direct costs if workers produce doors or windows only but are overheads if they produce both products.

Cost Assignment Method

• Direct costs are traced directly to the cost object.
• Overheads undergo cost allocation to be assigned to the cost object.
• Cost allocation is the process of assigning costs when the quantity of resources consumed by a particular cost object cannot be directly measured.

Full Cost

• Traditional cost systems accumulate costs.
• Full cost includes direct materials, direct labor, overheads.

Allocation Costing System

• This is a way for varying levels of sophistication for cost assignments.
• Simplistic systems include blanket rate systems
• Inexpensive to operate
• Extensive use of arbitrary cost allocations
• Low levels of accuracy
• High cost of errors
• Highly sophisticated systems include activity-based costing (ABC)
• Expensive to operate
• Extensive use of cause-and-effect cost allocations
• High levels of accuracy
• Low costs of error
• Department/traditional system lays in between Simplistic and Highly Sophisticated Systems.

Cost Driver

• Cost drivers measure the activity of each department.
• Examples include the number of goods produced, kilograms of material used, or hours worked.
• Overheads are assigned from department to cost objects based on cost driver consumption.
• The cost driver rate is calculated as the cost of the department divided by the number of cost drivers
• It allows for overhead allocation to the product.

Blanket Rate

• The allocation of overheads is based on a single overhead rate for the whole organization.
• Example: With total overheads of €24,780 and 1,000 products sold, the blanket overhead rate is €24.78 per product.
• If 100 doors and 900 windows are produced, overhead allocation is €2,478 to doors and €22,302 to windows.

Department/Traditional Costing System

• It accounts for the value chain and inventories, department definitions, overhead allocation to cost objects, and department cost driver rate.

Value Chain and Inventories

• The value chain is a sequence of business activities where value is added to products or services from the customer's perspective
• Primary activities include production and distribution
• Support activities support product development (administration, accounting, IT)
• Raw materials (wood and glass) are converted into finished goods
• Unprocessed wood goes through "wood cutting," then "wood aggregating," resulting in "aggregated wood.”
• "Aggregated wood" is separated in the “wood splitting” department into "wood for doors” and “wood for windows".
• "Wood for doors" goes through “door assembly" for finished doors.
• Glass goes through "glass melting" and "glass moulding" for "moulded glass".
• "Moulded glass” is assembled with "wood for windows” resulting in windows.
• Doors and windows are distributed to customers.
• Purchasing, production, and distribution are primary activities, while administration accounting are support activities.
• D&W has direct materials inventory and finished goods inventory.
• Direct materials inventory includes unprocessed wood and glass
• Finished goods inventory includes Doors and Windows

Department Definition

• Department centers divide company activity with homogeneous and measurable activity for overhead distribution.
• Department determination is specific to each company.
• Two kinds of departments:
  • Operational departments: purchasing, production, distribution assign overheads to cost objects
  • Service departments: administrative services, re-assign overheads from to operational departments

Method to Allocate Overheads to Cost Objects

• Two-stage allocation process:
  • Apportionment: assign overheads to departments
  • Absorption: allocate overheads from departments to cost objects
• Step 1: Assigning all overheads to operational and service departments
• Step 2: Re-assigning overheads from service departments to operational departments.
• Step 3: Calculate cost driver rates for each operational department.
• The cost driver rate is Department Overhead / Department quantity of cost drivers.
• Step 4: Calculate cost objects (inventories) Direct costs + Overheads = (number of cost drivers specific to the cost object) * (Cost driver rate).

Department Cost Driver Rate

• To produce doors and windows, wood goes through the "wood cutting" department with cutting overheads of €6,470, and is cost driver for the number of machine hours
• Machines ran for 200 hours that month, so the cost driver rate of cutting is calculated to be €32.35 per machine hour.