Cost Accumulation, Tracing, and Allocation PDF

Cost Accumulation, Tracing, and Allocation Chapter 12  CH12 – Key Concepts Cost Accumulation Cost Drivers & Cost Objects Cost Allocation  Why use costing? Managers must have reliable cost estimates to: Price products Evaluate performance Con...

Cost Accumulation, Tracing, and Allocation Chapter 12  CH12 – Key Concepts Cost Accumulation Cost Drivers & Cost Objects Cost Allocation  Why use costing? Managers must have reliable cost estimates to: Price products Evaluate performance Control operations Prepare financial statements Managers need to know the cost of many different things. The things for which we are trying to determine the cost are commonly called cost objects. Determine the Cost of Cost Objects Accountants use cost accumulation to determine the cost of a particular object. Assume a promotion of a ball game offering free baseball caps to all children who attend. Three cost components are: 1) The cost of the caps. 2) The cost of advertising the promotion. 3) The cost of an employee to work on the promotion.  Cost Accumulation Cost accumulation begins with identifying the cost objects. The primary cost object is the cost of the promotion. Three secondary cost objects are (1) the cost of caps, (2) the cost of advertising, and (3) the cost of labor. The costs of the secondary cost objects are combined to determine the cost of the primary cost object. Use of Cost Drivers to Accumulate Costs Units Machine produced hours A cost driver is any factor that causes or drives an activity’s costs Labor Miles hours driven A cost driver has a cause-and-effect relationship with a cost object. Cost Drivers and Cost Objects Determining the costs of the secondary cost objects requires identifying what drives these costs. The number of caps (cost driver) has an effect on the cost of caps (cost object). The number of advertisements is a cost driver for the advertising cost (cost object). The number of labor hours worked is a cost driver for the labor cost (cost object). Cost of the Primary Cost Object The promotion should be run if management expects it to produce additional revenues exceeding $15,800. Estimated versus Actual Cost Timely Relevant Potential Inaccuracies Estimated Costs Managers use estimated costs to make decisions about the future.  Estimated versus Actual Cost Managers use cost estimates to Actual cost data Set prices Published financial Bid on contracts reports Evaluate proposals Managerial performance Distribute resources evaluations Plan production Set goals Companies use cost estimates to establish goals and use actual costs to evaluate management performance in meeting those goals. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10  Assignment of Costs to Objects in a Retail Business In Style, Inc. (ISI) Retail clothing store Women’s, men’s, and children’s departments ISI began paying managers a bonus based on departmental sales revenue The bonus provoked negative consequences Future bonuses based on profitability Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 11 Identifying Direct and Indirect Costs The new bonus strategy requires determining the cost of operating each department. Assigning costs to the departments (cost objects) requires cost tracing and cost allocation. Direct costs can be easily traced to a cost object. Indirect costs cannot be easily traced to a cost object. Whether or not a cost is easily traceable requires cost / benefit analysis. Indirect costs are also called overhead costs. Income Statement Classification of Costs Direct Costs Indirect Costs  Cost Classifications Independent and Context Sensitive Whether a cost is direct or indirect is independent of whether it is fixed or variable. In the ISI example, both cost of goods sold and the cost of supplies vary relative to sales volume (both are variable costs), but cost of goods sold is direct and the cost of supplies is indirect. Furthermore, the cost of rent and the cost of depreciation are both fixed relative to sales volume, but the cost of rent is indirect and the cost of depreciation is direct. In fact, the very same cost can be classified as direct or indirect, depending on the cost object. Allocating Indirect Costs to Objects Common costs support multiple cost objects but cannot be traced to any specific object. For ISI, the cost of rent is a common cost. Responsibility can be motivated at the departmental level by allocating a portion of the rent cost to each department. The departmental managers should be held responsible for controllable costs (costs that can be influenced by a manager’s decisions and actions).  Cost Allocation Cost allocation involves dividing a total cost into parts and assigning the parts to designated cost objects. How should ISI allocate the $38,160 of indirect costs to each of the three departments? First, identify a cost driver for each cost to be allocated, for example store size drives rent cost. Then, achieve a rational allocation of the rent cost using the following two-step process.  Cost Allocation Process 2-Step Process Step #1 Compute the allocation rate Total costs to be allocated Total Cost Drive Step #2 Multiply the allocation rate Allocation rate by the weight of the cost x cost driver (per) driver to determine the = per cost object allocation per cost object, The cost driver is also called the allocation base. This computation produces the allocation rate  Cost Allocation - Template Rent Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $18400 ÷ 23000 sq.ft = $0.80 Step #2 Allocation Rate X Cost Driver (per) Per Cost Object Department's (1)Women's $0.80 X 12000 sq.ft = $9600 (2)Men's $0.80 X 7000 sq.ft = $5600 (3) Children $0.80 X 4000 sq.ft = $3200 (4)Total___ X = $18400 ____ (5)_______ X = X =  Cost Allocation - Template Utilities Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $2300 Utilities Cost ÷ 23000 sq.ft = $0.10 sq.ft Step #2 Allocation Rate X Cost Driver (per) Per Cost Object (1)Women’ $0.10 X 12000 = 1200 s (2)Men’s 0.10 X 7000 = 700 (3)Children’ 0.10 X 4000 = 400 s (4)Total X = 2300 (5)_______ X = X =  Determining the Cost to Be Allocated Using Cost Pools Allocating individually every single indirect cost a company incurs would be tedious and not useful relative to the benefit obtained. Instead, companies frequently accumulate many individual costs into a single cost pool. The total of the pooled cost is then allocated to the cost objects. For example, costs for gas, water, electricity and telephone could be accumulated into a single utilities cost pool.  Selecting the Cost Driver Companies can frequently identify more than one cost driver for a particular indirect cost. ISI’s cost of shopping bags provided to customers can be linked to both the number of sales transactions and the total amount of sales. ISI should use the driver with the strongest cause-and- effect relationship. Selecting the Best Cost Driver Since every sales transaction uses a shopping bag, the children’s department uses more shopping bags than the men’s department, even though it has a lower amount of total sales. Should ISI use the number of sales transactions to allocate supply cost to the departments? Availability of information also influences cost driver selection. ISI cannot use this allocation base unless it maintains a record of the number of sales transactions per department.  Cost Allocation - Template Supplies Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $900 supplies cost ÷ $360000 total sales = $0.0025 per sales $ Step #2 Allocation Rate X Cost Driver (per) Per Cost Object (1)Women’ $0.0025 X $190000 sales = $475 s (2)Men’s $0.0025 X $110000 = $275 (3)Children’ $0.0025 X $60000 = $150 s (4)Total___ X = $900 ____ (5)_______ X = X =  Cost Allocation - Template Advertising Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate 7200 Advertising ÷ $360000 = $0.02 per sales $ Step #2 Allocation Rate X Cost Driver (per) Per Cost Object (1)Women’ $0.02 X $190000 = $3800 s (2)Men’s 0.02 X $110000 = $2200 (3)Children 0.02 X $60000 = $1200 _______ (4)Total X = $7200 (5)_______ X = X = Cause-and-Effect Relationship There is no strong cause-and-effect relationship between the store manager’s salary and the departments. ISI pays the store manager the same salary regardless of sales level, square footage of store space, number of labor hours, or any other identifiable variable. Because no plausible cost driver exists, ISI must allocate the store manager’s salary arbitrarily, by dividing it equally among the departments.  Cost Allocation - Template Store Manager’s Salary Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $9360 Mgr. Monthly Salary ÷ 3 = $3120 per dept. Step #2 Allocation Rate X Cost Driver (per) Per Cost Object (1)Women’ $3120 X 1 = $3120 s (2)Men’s $3120 X 1 = $3120 (3) Children $3120 X 1 = $3120 (4)Total___ X = $9360 ____ (5)_______ X = X =  Behavioral Implications ISI paid the three departmental managers bonuses based on each department’s profitability. The store manager notices an immediate change in the behavior of the departmental managers. The manager of the women’s department offered to give up space because she believed that sales would not be reduced significantly. The manager of the children’s department wanted the extra space to display a competitive variety of merchandise. Profit Analysis by Department  Cost Drivers for Variable Overhead Costs A causal relationship exists between the variable overhead product costs (indirect materials, indirect labor, inspection costs, utilities, etc.) and the volume of production. Volume measures are good cost drivers for allocating variable overhead costs. Units Labor Materials Produced Hours Used  Using Units as the Cost Driver Filmier Furniture produced 4,000 chairs and 1,000 desks. It incurred $60,000 of indirect materials cost during the period. How much of this cost should Filmier allocate to chairs versus desks? Using number of units as the cost driver produces the following allocation. Units Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $60,000 Indirect Materials ÷ 5,000 Units = $12 per unit Step #2 Allocation Rate X Cost Driver (per) = Per Cost Object - Desks $12 per Unit X 1,000 = $12,000 - Chairs $12 per Unit X 4,000 = $48,000 - Total $60,000 Using Labor Hours as the Cost Driver Both direct labor hours and direct materials cost are volume measures that indicate Filmier uses more indirect materials to make a desk than a chair. It makes sense that the amount of direct labor used is related to the amount of indirect materials used. Because production workers use materials to make furniture, it is plausible to assume that the more hours they work, the more materials they use.  Using Direct Hours Labor as the Cost Driver Filmier incurs the following direct costs to make chairs and desks. Both direct labor hours and direct materials cost are volume measures. DL Hours Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $60,000 Indirect Materials ÷ 6,000 Hours = $10 per direct labor hour Step #2 Allocation Rate X Cost Driver (per) = Per Cost Object - Desks $10 per direct labor hour X 3,500 = $35,000 - Chairs $10 per direct labor hour X 2,500 = $25,000 - Total $60,000  Using Direct Materials Dollars as the Cost Driver If labor hours is an inappropriate allocation base, Filmier can consider direct materials usage, measured in material dollars, as the allocation base. It is likely that the more lumber (direct material) Filmier uses, the more glue, nails, and so forth (indirect materials) it uses. It is reasonable to presume direct materials usage drives indirect materials usage.  Using Direct Material as the Cost Driver Filmier incurs the following direct costs to make chairs and desks. Both direct labor hours and direct materials cost are volume measures. Direct Material (DM) Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $60,000 Indirect Materials ÷ $1,500,000 DM Cost = $04 per DM Dollar Step #2 Allocation Rate X Cost Driver (per) = Per Cost Object - Desks $04 per DM Dollar X 1,000,000 = $40,000 - Chairs $04 per DM Dollar X 500,000 = $20,000 - Total $60,000 Selecting the Best Cost Driver Which of the three volume-based cost drivers (units, labor hours, or direct material dollars) results in the most accurate allocation of the overhead cost? Management must use judgment to decide. In this case, If the cost Filmier If the cost Filmier was direct material was allocating allocating were dollars appears were fringe machine maintenance to have the most benefits, however, cost, a different convincing direct labor volume-based cost relationship to hours would be a driver, machine indirect materials more appropriate hours, would be an usage. cost driver. appropriate base. The most accurate allocations of indirect costs may actually require using multiple cost drivers Cost Drivers for Fixed Overhead Costs Fixed costs present a different cost allocation problem. By definition, the volume of production does not drive fixed costs. The objective of allocating fixed costs to products is to distribute a rational share of the overhead cost to each product. Selecting an allocation base that spreads total overhead cost equally over total production often produces a rational distribution.  Allocating Fixed Overhead Costs Lednicky Bottling Company rents its manufacturing facility for $28,000 per year. Assume Lednicky produced 2,000,000 bottles of apple juice during the current accounting period. If it sold 1,800,000 bottles of the juice during this period, how much of the $28,000 rental cost should Lednicky allocate to ending inventory and to cost of goods sold? Fixed Overhead Allocation Step #1 Total Costs to be ÷ Total Costs Driver = Allocation Rate allocated $28,000 Rent ÷ 2,000,000 Bottles Produced = $.014 per Bottle Step #2 Allocation Rate X Cost Driver (per) = Per Cost Object - Inventory $.014 per Bottle X 200,000 = $2,800 - COGS $.014 per Bottle X 1,800,000 = $25,200 - Total $28,000  Allocating Fixed Costs When the Volume of Production Varies Monthly fluctuations in production volume complicate fixed cost allocations. Assume Grave Manufacturing pays its supervisor $3,000 monthly and production varies by month, the allocation rate will vary by month. If prices are based on these costs, units produced in January will be priced higher than those produced in February. Will customers think this is reasonable? Grave Manufacturing can estimate the annual cost of the supervisor’s salary and the annual production volume. Because the overhead allocation rate is determined before actual cost and volume data are available, it is called the predetermined overhead rate (POHR).  Predetermined Overhead Rate Grave Manufacturing estimates its supervisor’s salary at $36,000 per year and estimates total annual production volume at 18,000 units. Compute the allocation rate. Fixed Overhead Allocation Step #1 Total Costs to be allocated ÷ Total Costs Driver = Allocation Rate $36,000 Supervisor Salary ÷ 18,000 Production Units = $2.00 per Unit Step #2 Allocation Rate X Cost Driver (per) = Per Cost Object - January $2.00 per Unit X 800 = $1,600 - February $2.00 per Unit X 1,875 = $3,750 Cost Allocation: The Human Factor Cost allocations significantly affect individuals. They many influence managers’ performance evaluations and compensation. They may dictate the amount of resources various departments, divisions, and other organizational receive. Control over resources usually offers managers prestige and influence over organization operations. The following scenario illustrates the emotional impact and perceptions of fairness of cost allocation decisions.  Using Cost Allocations in a Budgeting Decision Dean Southport is addressing the allocation of copying resources. Assumptions: Total budgeted cost is $36,000. Departmental allocations: $12,000 for management, $10,000 for accounting, $8,000 for finance, and $6,000 for marketing. Management department protested. Management has more faculty than other departments. Copy funds should be allocated based on the number of faculty members. The School of Business has 72 faculty members (29 in management, 16 in accounting, 12 in finance, and 15 in marketing), the allocation should be as follows.  Using Cost Drivers to Make Allocations The School of Business has 72 faculty members (29 in management, 16 in accounting, 12 in finance, and 15 in marketing), the allocation should be as follows. Using Cost Drivers Step #1 Total Costs to be ÷ Total Costs Driver = Allocation Rate allocated $36,000 Budget ÷ 72 Faculty Members = $500 per faculty Step #2 Allocation Rate X Cost Driver (per) = Per Cost Object Allocation Allocation per based on Department past usage Mgmt $500 per faculty X 29 = $14,500 $12,000 Accounting $500 per faculty X 16 = $8,000 $10,000 Finance $500 per faculty X 12 = $6,000 $8,000 Marketing $500 per faculty X 15 = $7,500 $6,000 Total $36,000 $36,000  The Human Factor Dr. Smethers questioned the accuracy of using the number of faculty members as the cost driver. He suggested the number of students rather than the number of faculty members drives the cost of copying. Because his department teaches more students, it spends more on copying costs even though it has fewer faculty members.  Allocating By Number of Students University records indicate that the School of Business taught 1,200 students during the most recent academic year. Using Cost Drivers Step #1 Total Costs to be ÷ Total Costs Driver = Allocation Rate allocated $36,000 Budget ÷ 1,200 Students = $30 per Student Step #2 Allocation Rate X Cost Driver (per) = Per Cost Object Allocation Allocation per based on Department past usage Mgmt $30 per Student X 330 = $9,900 $12,000 Accounting $30 per Student X 360 = $10,800 $10,000 Finance $30 per Student X 290 = $8,700 $8,000 Marketing $30 per Student X 220 = $6,600 $6,000 Total $36,000 $36,000  Choosing the Best Cost Driver and Controlling Emotions Dr. Thompson objected vigorously to using the number of students as the cost driver, arguing that the size of the faculty is a more appropriate allocation base. The chair of the finance department sided with Dr. Smethers. The dean decided the number of students has the most significant impact on copying costs. Technical expertise in computing numbers is of little use without the interpersonal skills to persuade others. End of Presentation