accounting chapter 24

Cost Allocation and

Responsibility Accounting

Chapter 24

24-1Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Learning Objectives

1. Assign direct costs and allocate indirect costs using predetermined overhead allocation rates with single and multiple allocation bases

2. Explain why companies decentralize and use responsibility accounting


Learning Objectives

3. Describe the purpose of performance evaluation systems and how the balanced scorecard helps companies evaluate performance

4. Use responsibility reports to evaluate cost, revenue, and profit centers


Learning Objectives

5. Use return on investment (ROI) and residual income (RI) to evaluate investment centers

6. Determine how transfer pricing affects decentralized companies (Appendix 24A)


Learning Objective 1

Assign direct costs and Assign direct costs and allocate indirect costs allocate indirect costs using predetermined using predetermined overhead allocation overhead allocation rates with single and rates with single and

multiple allocation multiple allocation basesbases


Ways to Allocate Indirect Costs

• Plantwide rate

• Multiple department rates

• Activity-based costing

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall 24-6

Data for Smart Touch Learning


Predetermined Overhead Allocation Rate Using Single Plantwide Rate


Overhead Allocation Process UsingSingle Plantwide Rate


Total Cost per Unit UsingSingle Plantwide Rate


Overhead Allocation ProcessUsing Department Rates


Total Cost per Unit Using Departmental Rates


Summary


Examples of Activities and Allocation Bases


Activity-Based Costingfor Smart Touch Learning


Smart Touch Learning’sEstimated Manufacturing Overhead


Overview of Smart Touch Learning’s Traditional and ABC Systems


ManufacturingOverhead

Panel A: TraditionalSystem

DirectLabor CostAllocation Base

ManufacturingOverhead

ProductionSetup

Panel B: ABC System

Activity Testing

Number ofBatches

Direct LaborHours

Number ofTests

Standard Model Premium ModelStandard Model Premium Model

Allocation Bases

ProductsProducts

Exhibit 24-4 Overview of Smart Touch Learning’s Traditional and ABC SystemsExhibit 24-4 Overview of Smart Touch Learning’s Traditional and ABC Systems

Predetermined OverheadAllocation Rate


Allocation of Indirect Costs and Computation of Overhead Cost per Unit


Total Cost per Unit


Traditional Costing Systems Compared to ABC Systems



Newton Company has analyzed its production process and identified two primary activities. These activities, their allocation bases, and estimated costs are listed below:

Activity Allocation Base Estimated Activity Estimated Costs

Purchasing Number of purchase orders 200 purchase orders $10,000

Materials handling Number of parts 15,000 parts $ 7,500

The company manufactures two products: Regular and Super. The products use the following resources in March:

Regular Super

Number of purchase orders

5 purchase orders 7 purchase orders

Number of parts 600 parts 750 parts

1. Compute the predetermined overhead allocation rates using activity-based costing.


1. Compute the predetermined overhead allocation rates using activity-based costing.

Predetermined overhead allocation rate for Purchasing:

= Total estimated overhead costs / Total estimated quantity of the overhead allocation base

= $10,000 / 200 purchase orders

= $50 per purchase order

Predetermined overhead allocation rate for Materials Handling:

= Total estimated overhead costs / Total estimated quantity of the overhead allocation base

= $7,500 / 15,000 parts

= $0.50 per part


2. Determine the amount of overhead allocated to Regular in March.


2. Determine the amount of overhead allocated to Regular in March.

Allocated Manufacturing Overhead Cost for Regular for Purchasing:

= Predetermined overhead allocation rate × Actual quantity of the allocation base used

= $50 per purchase order × 5 purchase orders

= $250

Allocated Manufacturing Overhead Cost for Regular for Materials Handling:


= $0.50 per part × 600 parts

= $300

Total overhead allocated to Regular

= $250 + $300

= $550


3. Determine the amount of overhead allocated to Super in March.


3. Determine the amount of overhead allocated to Super in March.

Allocated Manufacturing Overhead Cost for Super for Purchasing:


= $50 per purchase order × 7 purchase orders

= $350

Allocated Manufacturing Overhead Cost for Super for Materials Handling:


= $0.50 per part × 750 parts

= $375

Total overhead allocated to Super

= $350 + $375

= $725



Explain why Explain why companies companies

decentralize and use decentralize and use responsibility responsibility

accountingaccounting


Organization of a Business

• Centralized

• Decentralized


Advantages of Decentralization

• Frees top management time

• Supports use of expert knowledge

• Improves customer relations

• Provides training

• Improves motivation and retention


Disadvantages of Decentralization

• Duplication of costs

• Problems achieving goal congruence


Responsibility Centers


Smart Touch LearningOrganization Chart (Partial)


Fill in the blanks with the phrase that best completes the sentence. Some phrases may be used more than once and some not at all.

Phrases:

cost center revenue center

investment center lower

profit center higher

responsibility center

4. The maintenance department at the local zoo is a(n)

_______________.

5. The concession stand at the local zoo is a(n) _______________.

6. The menswear department of a department store, which is

responsible for buying and selling merchandise, is a(n) _______________.

7. The production line at a manufacturing plant is a(n)

_______________.Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall 24-39


Phrases:






_______________.






cost center


Phrases:






_______________.






cost center

profit center


Phrases:






_______________.






cost center

profit center

profit center


Phrases:






_______________.






cost center

profit center

profit center

cost center


Phrases:





8. A(n) _________________ is any segment of the business whose manager is accountable for specific activities.

9. A brand of soft drink, a division of a beverage manufacturing company, is a(n) _________________.

10.The sales manager in charge of a shoe company’s northwest sales territory oversees a(n) _______________.

11. Managers of cost and revenue centers are at _______________ levels of the organization than are managers of profit and investment centers.


Try It!


Phrases:












Phrases:











investment center


Phrases:











investment center

revenue center


Phrases:











investment center

revenue center

lower


Describe the purpose Describe the purpose of performance of performance

evaluation systems evaluation systems and how the balanced and how the balanced

scorecard helps scorecard helps companies evaluate companies evaluate

performanceperformance


Goals of PerformanceEvaluation Systems

• Promoting goal congruence and coordination

• Communicating expectations

• Motivating segment managers

• Providing feedback

• Benchmarking


Limitations of FinancialPerformance Measures

• Lag indicators

• Focus on short-term achievements


Balanced Scorecard

• Performance evaluation system that requires management to consider:– Financial performance measures (lag

indicators)– Operational performance measures (lead

indicators)• Should link these measures with the company’s:

– Goals– Strategy for achieving those goals


Balanced Scorecard


Classify each key performance indicator according to the balanced scorecard perspective it addresses. Choose from the following: financial perspective, customer perspective, internal business perspective, learning and growth perspective.

12. Number of repeat customers

13. Employee turnover

14. Revenue growth

15. Number of on-time deliveries

16. Number of defects found during manufacturing process




customer perspective

13. Employee turnover

14. Revenue growth







13. Employee turnover learning and growth perspective

14. Revenue growth








14. Revenue growth financial perspective





Use responsibility Use responsibility reports to evaluate reports to evaluate cost, revenue, and cost, revenue, and

profit centersprofit centers


Responsibility Accounting Performance Reports


Controllable Cost

• Cost that the manager has the power to influence by his or her decisions

• All costs are ultimately controllable at the upper levels of management

• Controllability decreases as responsibility decreases

• Responsibility accounting performance report (responsibility report) is completed for each manager of a business segment


Performance Report versus Responsibility Report—Cost Center


Responsibility Report—Revenue Center


Performance Report—Profit Center


Responsibility Report—Profit Center


Match the responsibility center to the correct responsibility report.

Responsibility Centers Responsibility Reports

17. Cost center a. Includes flexible budget variances for revenues and costs

18. Revenue center b. Includes flexible budget variances for costs

19. Profit center c. Includes flexible budget variances and sales volume variances for revenues



Use return on Use return on investment (ROI) and investment (ROI) and

residual income (RI) to residual income (RI) to evaluate investment evaluate investment

centerscenters


Investment Centers

• Large divisions of a company• Manager’s duties are similar to those of a CEO

– Generate profit– Make the best use of the assets


Financial Evaluation of Investment Centers Must Measure:

• How much operating income the segment is generating

• How efficiently the segment is using its assets


Smart Touch Learning—Data on Divisions


Return on Investment (ROI)

ROI = Operating incomeAverage total assets




e-Learning Division’s ROI = $450,000

$2,500,000 = 0.18 = 18%




e-Learning Division’s ROI = $450,000

$2,500,000 = 0.18 = 18%

Tablet Computer Division’s ROI = $975,800

$6,500,000 = 0.15 = 15%


Expanded ROI Equation

ROI = Operating incomeNet sales

×Net sales

Average total assets= Operating income

Average total assets


Profit Margin Ratio


Profit margin ratio =Operating income

Net sales

Profit Margin Ratio



Net sales

e-Learning Division’sprofit margin ratio

= $450,000

$7,500,000 = 0.06 = 6%

Profit Margin Ratio



Net sales

e-Learning Division’sprofit margin ratio

= $450,000

$7,500,000 = 0.06 = 6%

Tablet Computer Division’sprofit margin ratio

= $975,800

$5,243,600 = 0.19 =19%

Asset Turnover Ratio


Asset turnover ratio =Net sales






e-Learning Division’sasset turnover ratio

=$7,500,000$2,500,000 = 3.00





e-Learning Division’sasset turnover ratio

=$7,500,000$2,500,000 = 3.00

Tablet Computer Division’sasset turnover ratio

=$5,243,600$6,500,000 = 0.81

Expanded ROI Equation


Drawback of ROI—Example

• Companywide target ROI of 16%• Both divisions are considering investing in

in-store video display equipment that shows customers how to use featured products– Cost is $100,000– Expected annual operating income is

$17,000


Drawback of ROI—Example


Equipment ROI = $17,000$100,000 = 0.17 = 17%

Residual Income


RI = Operating income − Minimum acceptable operating income

RI = Operating income − (Target rate of return × Average total assets)

Residual Income




e-Learning Division’s RI = $450,000 − (16% × $2,500,000)

= $450,000 − $400,000

= $ 50,000

Residual Income





= $450,000 − $400,000

= $ 50,000

Tablet Computer Division’s RI = $975,800 − (16% × $6,500,000)

= $975,800 − $1,040,000

= $(64,200)

Residual Income





= $450,000 − $400,000

= $ 50,000

Tablet Computer Division’s RI = $975,800 − (16% × $6,500,000)

= $975,800 − $1,040,000

= $(64,200)

Equipment RI = $17,000 − (16% × $100,000)

= $17,000 − $16,000

= $ 1,000

Investment Center KPIs


Measurement Issues

• Average total assets• Do not include nonproductive assets• Gross book value of assets (the historical cost of

the assets) or net book value of assets (historical cost less accumulated depreciation)?


Short-Term Focus of Financial Performance Measures

• Calculated over a one-year time frame or less• Incentive to take actions that will lead to an

immediate increase in measures, even if such actions may not be in the company’s long-term interest

• Some potentially positive actions considered by subunit managers may take longer than one year to generate income at the targeted level


Padgett Company has compiled the following data:Net sales $ 1,000,000Operating income 60,000Average total assets 400,000Management’s target rate of return 12%

Calculate the following amounts for Padgett:

20.Profit margin ratio




20.Profit margin ratio

Profit margin ratio = Operating income / Net sales

= $60,000 / $1,000,000

= 6%




21.Asset turnover ratio




21.Asset turnover ratio

Asset turnover ratio = Net sales / Average total assets

= $1,000,000 / $400,000= 2.5




22.Return on investment




22.Return on investmentROI = Operating income / Average total assets= $60,000 / $400,000= 15%ROI = Profit margin ratio × Asset turnover ratio= 6% × 2.5= 15%




23.Residual income




23.Residual income


= $60,000 − (12% × $400,000)= $60,000 − $48,000= $12,000



Determine how transfer Determine how transfer pricing affects pricing affects decentralized decentralized

companiescompanies

(Appendix 24A)(Appendix 24A)


Objectives in Setting Transfer Prices

• To achieve goal congruence by selecting a price that will maximize overall company profits

• To evaluate the managers of the responsibility centers involved


Data for Online Courses in Smart Touch Learning’s e-Learning Division


Transfer Price Negotiable Range

Variable Costs$60

Contribution Margin$40


Exhibit 24-13 Transfer Price Negotiable RangeExhibit 24-13 Transfer Price Negotiable Range

$0 $60 $100

Negotiable Range

MarketPrice

Setting the Transfer Price

• If operating at capacity– Use the market-based transfer price (sales

price charged to customers outside the company)

• If operating below capacity– Use a cost-based transfer price (any amount

equal to or above the variable cost)


Other Issues

• International issues

• Legal and ethical issues

• Difficult to determine a market price

• Nonfinancial issues


Sheffield Company manufactures power tools. The Electric Drill Division (an investment center) can purchase the motors for the drills from the Motor Division (another investment center) or from an outside vendor. The cost to purchase from the outside vendor is $20. The Motor Division also sells to outside customers. The motor needed by the Electric Drill division sells for $25 to outside customers and has a variable cost of $15. The Motor Division has excess capacity.


24A. If Sheffield Company allows division managers to negotiate transfer prices, what is the minimum amount the manager of the Motor Division should consider?

25A. What is the maximum transfer price the manager of the Electric Drill Division should consider?



The Motor Division has excess capacity, so the manager should consider the variable cost of $15 for the minimum transfer price.




The Motor Division has excess capacity, so the manager should consider the variable cost of $15 for the minimum transfer price.


The Electric Drill Division can purchase the motors from an outside vendor for $20, so that is the maximum amount the manager should consider.


Key Terms

• Decentralized Company• Goal Congruence• Investment Center• Key Performance Indicator (KPI)• Lag Indicator• Lead Indicator• Market-Based Transfer Price• Opportunity Cost


End of Chapter 24


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