finman managerial 11e im ch26(11) final

chapter

26(11)Cost Allocation and Activity-Based Costing______________________________________________

OPENING COMMENTS

Chapter 26(11) deals with the distortion that can occur in product costing if overhead is not applied properly. It presents three methods for allocating overhead: (1) a single plantwide factory overhead rate, (2) multiple production department factory overhead rates, and (3) activity-based costing (ABC). As you cover these methods, stress that they represent a trade-off between accuracy and complexity. While ABC provides a more accurate means to trace overhead costs to products, it is also more complex and more expensive to implement. However, with global competition squeezing the prices many businesses can charge for their products and services, an accurate product cost is becoming crucial. For many companies, the benefits of ABC far outweigh the costs of implementing this new system.

After studying this chapter, your students should be able to:

1. Identify three methods used for allocating factory overhead costs to products.

2. Use a single plantwide factory overhead rate for product costing.

3. Use multiple production department factory overhead rates for product costing.

4. Use activity-based costing for product costing.

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148 Chapter 26(11) Cost Allocation and Activity-Based Costing

5. Use activity-based costing to allocate selling and administrative expenses to products.

6. Use activity-based costing in a service business.

STUDENT FAQS Which of the three methods for allocating factory overhead cost to products is better?

Why would someone choose the multiple production department FOH rate method when it is more complicated to calculate than the single plantwide rate?

How is the selection of the allocation base for a production department made?

How does the activity-based costing method differ from the single plantwide and the multiple production department FOH rate methods?

In service departments, how would activity-based costing be used?

Which of the three methods for allocating costs of products can lead to significant product cost distortions?

Can activity-based costing be used in service businesses? If so, how?

Why are selling and administrative expenses often allocated by an activity-based costing method rather than sales volume?

How are activity-based rates determined?

What is an activity base?

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26(11)

Cost Allocation and Activity-Based Costing

Upcoming Chapter

27(12)

Cost Management for Just-in-Time Environments

IN-CLASS AND HOMEWORK ASSIGNMENT CHARTNumber Objective Description Difficulty Time AACSB IMA SS GL

EO26(11)-1 26(11)-1 Easy 5 min Analytic Cost Management





EO26(11)-6 26(11)-3 Easy 5 min Analytic Cost


Number Objective Description Difficulty Time AACSB IMA SS GL

Management











PE26(11)-1A 26(11)-2 Single plant wide overhead rate

Easy 10 min Analytic Cost Management

PE26(11)-1B 26(11)-2 Single plant wide overhead rate


PE26(11)-2A 26(11)-3 Multiple production department factory overhead rates


PE26(11)-2B 26(11)-3 Multiple production department factory overhead rates


PE26(11)-3A 26(11)-4 Activity-based costing: factory overhead costs




PE26(11)-3B 26(11)-4 Activity-based costing: factory overhead costs


PE26(11)-4A 26(11)-5 Activity-based costing—selling and administrative expenses


PE26(11)-4B 26(11)-5 Activity-based costing—selling and administrative expenses


PE26(11)-5A 26(11)-6 Activity- based costing: service business


PE26(11)-5B 26(11)-6 Activity- based costing: service business


Ex26(11)-1 26(11)-2 Single plantwide overhead rate






Ex26(11)-4 26(11)-2 Product costs and product profitability reports, using s single plant wide factory overhead rate

Moderate 30 min Analytic Cost Management

Exl

Ex26(11)-5 26(11)-3 Multiple production department factory overhead rate method


Exl

Ex26(11)-6 26(11)-2, 26(11)-3

Single plant wide and multiple production department factory overhead rate methods and product cost distortion


Ex26(11)-7 26(11)-2, 26(11)-3

Single plant wide and multiple production department factory overhead rate methods and product cost distortion


Ex26(11)-8 26(11)-4 Identifying activity Easy 10 min Analytic Cost



bases in an activity-based cost system

Management

Ex26(11)-9 26(11)-4 Product costs using activity rates


Ex26(11)-10 26(11)-4 Product costs using activity rates


Exl

Ex26(11)-11 26(11)-4 Activity rates and product costs using activity-based costing


Exl

Ex26(11)-12 26(11)-4 Activity cost pools, activity rates, and product costs using activity-based costing


Exl

Ex26(11)-13 26(11)-2, 26(11)-4

Activity-based costing and product cost distortion


Exl

Ex26(11)-14 26(11)-3 Multiple production department factory overhead rate method


Exl

Ex26(11)-15 26(11)-4 Activity-based costing and product cost distortion


Exl

Ex26(11)-16 26(11)-2, 26(11)-4

Single plant wide rate and activity-based costing


Exl

Ex26(11)-17 26(11)-5 Evaluating selling and administrative cost allocations


Ex26(11)-18 26(11)-5 Construct and interpret a product profitability report, allocating selling and administrative expenses


Ex26(11)-19 26(11)-6 Activity-based costing and customer

Moderate 30 min Analytic Cost



profitability Management

Ex26(11)-20 26(11)-6 Activity-based costing for a hospital


Exl

Ex26(11)-21 26(11)-5, 26(11)-6

Activity-base costing an insurance company


Exl

Pr26(11)-1A 26(11)-2 Single plantwide factory overhead rate


Pr26(11)-2A 26(11)-3 Multiple production department factory overhead rates


Pr26(11)-3A 26(11)-3, 26(11)-4

Activity-based and department rate product costing and product cost distortions

Difficult 1 3/4 hr

Analytic Cost Management

Exl

Pr26(11)-4A 26(11)-4 Activity-based product costing

Moderate 1 hr Analytic Cost Management

Exl

Pr26(11)-5A 26(11)-5 Allocating selling and administrative expenses using activity-based costing

Difficult 1 3/4 hr


Exl

Pr26(11)-6A 26(11)-6 Product costing and decision analysis for a passenger airline


Exl

Pr26(11)-1B 26(11)-2 Single plantwide factory overhead rate


Pr26(11)-2B 26(11)-3 Multiple production department factory overhead rates


Pr26(11)-3B 26(11)-3, 26(11)-4

Activity-based and department rate product costing and product cost distortions

Difficult 1 3/4 hr


Exl

Pr26(11)-4B 26(11)-4 Activity-based product costing


Exl

Pr26(11)-5B 26(11)-5 Allocating selling and administrative expenses using activity-based

Difficult 1 3/4 hr


Exl



costing

Pr26(11)-6B 26(11)-6 Product costing and decision analysis for a hospital


Exl

SA26(11)-1 26(11)-5 Ethics and professional conduct in business

Moderate 15 min Ethics Ethical Considerations

SA26(11)-2 26(11)-2 Identifying product cost distortion


SA26(11)-3 26(11)-4 Activity-based costing Moderate 20 min Analytic Cost Management

SA26(11)-4 26(11)-2 Using a product profitability report to guide strategic decisions


SA26(11)-5 26(11)-3 Product cost distortion Moderate 30 min Analytic Cost Management

SA26(11)-6 26(11)-5 Allocating bank administrative costs


OBJECTIVE 1

Identify three methods used for allocating factory overhead costs to products.

KEY TERMS

Product Costing

SUGGESTED APPROACH

TM 26(11)-1 lists the three overhead allocation methods presented in this chapter: (1) a single plantwide factory overhead rate, (2) multiple production department factory overhead rates, and (3) activity-based costing (ABC). It also shows that these methods vary in complexity and accuracy.


OBJECTIVE 2

Use a single plantwide factory overhead rate for product costing.

KEY TERMS

Single Plantwide Factory Overhead Rate Method

SUGGESTED APPROACH

In this objective, the text reviews the method for allocating overhead that was used in Chapter 17(2) under job order costing. The single plantwide overhead rate is calculated as follows:

Single Plantwide Total Budgeted Factory Overhead Costs

Factory Overhead Rate = Total Budgeted Allocation Base

Point out that this is the same formula as was used to calculate a predetermined overhead rate in Chapter 17(2). A company is using a single plantwide overhead rate if it calculates only one predetermined overhead rate that is used by all departments to allocate overhead costs.

GROUP LEARNING ACTIVITY—Plantwide Overhead Rate

TM 26(11)-2 asks your students to calculate a single plantwide overhead rate and use that rate to apply overhead to products. By working in groups to solve this problem, your students will review this basic overhead allocation method. You may want to refer them to the formula for calculating a predetermined overhead rate in Chapter 17(2) to emphasize the correlation between the concepts in Chapters 17(2) and 26(11). The solution to this problem is presented on TM 26(11)-3.

OBJECTIVE 3

Use multiple production department factory overhead rates for product costing.

KEY TERMS

Multiple Production Department Factory Overhead Rate Method


Production Department Factory Overhead Rates

SUGGESTED APPROACH

When production departments differ significantly in their costs and operations, multiple production department factory overhead rates may yield a more accurate product cost than the single plantwide factory overhead rate. Under the multiple department rate method, overhead costs are traced to each production department and applied to products based on the departmental resources consumed. The demonstration problem below will assist you in illustrating this method.

DEMONSTRATION PROBLEM—Multiple Production Department Factory Overhead Rates

TM 26(11)-2 presented information for Franklin Manufacturing. Use this TM as a basis for illustrating the multiple production department rate method.

Franklin Manufacturing had traced its factory overhead costs to the company’s two production departments. These costs are:

Production Dept. #1—$160,000

Production Dept. #2—$340,000

You may want to point out that, although the text does not show an example where plantwide overhead costs are allocated to production departments, this is a necessary step for most companies using departmental overhead rates. This additional complexity is omitted from the chapter in order to simplify the discussion.

Once the overhead costs have been assigned to each production department, the company must choose the basis for allocating overhead to products. Assume that overhead costs will be allocated based on direct labor hours in Dept. #1 (a labor-intensive department) and machine hours in Dept. #2 (a more automated department). Budgeted direct labor and machine hours for these departments are:

Production Dept. #1—12,000 direct labor hours

Production Dept. #2—10,000 machine hours


The departmental overhead rates would be calculated as follows:

Production Dept. #1:

Production Dept. #2:

On TM 26(11)-2, your students were asked to calculate the overhead allocated to a product using a single plantwide factory overhead rate. Now, instruct your students to calculate the overhead allocated to that same product using departmental overhead rates, assuming the product used 2 direct labor hours in Dept. #1 and 4 machine hours in Dept. #2.

Overhead Allocated in Dept. #1: 2 direct labor hours × $13.33/hr. = $ 26.66

Overhead Allocated in Dept. #2: 4 machine hours × $34.00/hr. = 136.00

Total $162.66

Ask your students to comment on the differences in overhead allocated to Franklin’s product using the single plantwide rate and multiple department rates. With the single plantwide rate, all overhead is allocated based on direct labor hours even though the overhead costs in Dept. #2 are machinery related. By allocating Dept. #2 costs based on machine hours, the products that use the most machine time will be allocated the most overhead, which is rational for a highly automated department. The single rate averages all factory overhead costs together, rather than reflecting the departmental resources consumed.

OBJECTIVE 4

Use activity-based costing for product costing.

KEY TERMS

Activity Base Activity-Based Costing (ABC) Method

Activity Cost Pools Engineering Change Order (ECO)


Activity Rate Setup

SUGGESTED APPROACH

TM 26(11)-4 illustrates the allocation of overhead in an ABC system. In an ABC system, management must identify all the activities necessary to manufacture a product. Overhead costs are then allocated to these activities, forming activity cost pools. For example, one activity that absorbs overhead costs is machine setup. Under ABC, all costs incurred in setting up machines would be allocated to the setup activity cost pool.

The goal of ABC is to allocate overhead to products based on the activities they consume in the manufacturing process. After defining an activity cost pool, an activity base is selected to link the overhead costs to the product. Continuing with the machine setup example, the total setup cost pool could be linked to products based on the number of times they require machines to be set up for production.

The illustration in TM 26(11)-4 assumes a simple manufacturing process with only three activities. Therefore, there are only three activity cost pools from which to allocate costs to the five products produced.

While discussing ABC, stress the following points:

1. ABC changes only the way overhead costs are allocated. Direct materials and direct labor costs are still traced to products.

2. When identifying the activities needed to manufacture their product, many companies find inefficiencies that they didn’t know existed. These inefficiencies can be eliminated, reducing the product’s cost.

3. ABC gained popularity because many manufacturing experts believed that traditional cost accounting “undercosted” complex products. Assigning too little cost to a product overstates its profit margin.

4. Many companies developed ABC systems independently of their cost accounting systems. In such cases, ABC is used only for decision making. It is not used for inventory valuation or decision making.


LECTURE AID—The Need for Activity Based Costing

The following real-world example illustrates how traditional cost systems can understate the cost of complex products.

A manufacturer of surgical gloves traditionally made gloves in one color: white. The company received a request from one of its customers to make each size glove a different color. The customer wanted small gloves to be pink, medium to be yellow, and large to be green.

Every time the manufacturer would start to produce a colored glove, the machines would have to be shut down while colored dye was pumped into them. At the end of the production run, workers had to clean the machines to remove the remaining dye. The special setup and cleaning caused the company to spend more on labor to make the colored gloves.

No matter how thoroughly the machines were cleaned after producing a colored glove, they still contained residue from the dye. To remove the residue, materials had to be run through the machine. So a batch of gloves was made and scrapped just to prepare the machine to make white (or another color) gloves.

The company allocated overhead based on machine hours. Since the white and colored gloves used exactly the same machine time while they were being made, they were assigned the same amount of overhead. As a result, the colored gloves were “undercosted” because they were clearly more expensive to produce.

Another example (used by Cooper and Kaplan) is two pen factories—one that sells only blue pens and one that sells pens of all colors. Both sell 100,000 pens per month. Assume you walk into the multicolor pen factory, but you’re colorblind. How would you know you are in the factory that makes a variety of pen colors? Answer: There would be more activities than in the blue pen factory, such as color cleanouts, additional materials requisitions and purchasing, more quality checks and rework, etc.

DEMONSTRATION PROBLEM—Activity Based Costing

Allocating overhead to products under an ABC system can be explained as a four-step process.

Step 1: Identify activities. ABC costing allocates overhead to the activities that consume overhead costs. This forces a company to identify the activities necessary to make its product.


For example, assume that a manufacturing company identifies the following activities as necessary to make a product:

1. Order materials.

2. Receive and inspect materials.

3. Schedule production.

4. Set up machines to make the product.

5. Make the product.

6. Inspect the finished product.

7. Pack and ship the product to the customer.

Step 2: Allocate costs of the activities into activity cost pools. The company would start this step by determining the overhead costs it incurs to order materials (the first activity). Assume that these costs total $80,000 and include such items as the salaries of the purchasing agent(s) and staff, supplies used by the purchasing department, and depreciation on office equipment used by the purchasing department.

Step 3: Select an activity base. A means to allocate the cost of each activity to the product must be chosen. This is known as selecting an activity base (also called an activity driver). The activity base for any activity should be the event that causes costs to be incurred. For example, placing an order causes purchasing costs to be incurred.

Step 4: Calculate an activity rate and allocate costs to products. Assume that the purchasing department places 10,000 orders per year. The cost to place an order is calculated as follows:

Activity Rate: $80,000

Cost to place an order = 10,000 orders = $8 per order


If manufacturing a product causes the purchasing agent to place two orders for materials, the overhead cost allocated to that product as the result of ordering materials is $16.

Once this process is complete for the purchasing activity, the same steps must be taken for the remaining activities. As a result, ABC is usually implemented only with the use of a computer programmed to do the many calculations required.

Problem 26(11)-3A or 26(11)-3B (depending on homework assignment) can be used to demonstrate ABC further if desired.

OBJECTIVE 5

Use activity-based costing to allocate selling and administrative expenses to products.

SUGGESTED APPROACH

Objective 5 presents an overview of how activity-based costing can be applied to selling and administrative expenses. Use the group learning activity below to turn these concepts into something concrete.

GROUP LEARNING ACTIVITY—ABC Applied to Selling and Administrative Costs

Exhibit 11 in the text lists the selling and administrative activities for two products, Ipso and Facto. These products consume dramatically different amounts of selling and administrative attention. TM 26(11)-5 presents hypothetical dollar amounts for each of those activities.

Divide your class into small groups and ask each group to discuss possible activity bases that could be used to allocate each cost. You may want to help your students start this project by suggesting possible activity bases for the first and/or second activity.

Activity Possible Activity Base


Post-Sale Technical Support Hours Spent Training Customers

Number of Training Sessions Provided to Customers

Time Spent Assisting Customers on a 1-800 Technical

Support Hotline

Order Writing Hours Spent Writing Up Customer Orders

Number of Technical Drawings Accompanying Orders

Number of Pages in the Customer Orders

Encourage your students to come up with more than one possible activity base for each activity. After the groups have formulated their responses, ask them to share their ideas with the class.

Next, tell your students that Abacus Company (the retailer for Ipso and Facto) has selected the activity bases listed on TM 26(11)-6 for allocating cost. Instruct your students to use this information to determine the activity rates for Abacus and the costs that should be allocated to Ipso and Facto. The solution is presented on TM 26(11)-7.

OBJECTIVE 6

Use activity-based costing in a service business.

SUGGESTED APPROACH

The steps necessary to implement activity-based costing explained under Objective 4 can be applied to either a manufacturing or a service business. The following writing exercise will help your students apply these concepts to a service company.

WRITING EXERCISE—ABC in a Service Business

In Exhibit 12, the text divides the operations of a hospital into five activities and assigns a cost to each of these activities. As a result, each customer is assigned only the costs of the hospital services (activities) he or she uses.


Ask your students to select another type of service business and list the activities that business would perform in providing its services to customers. Next, ask your students to write a memo to the owner of that business explaining how activity-based costing could assist him/her with managing the business.

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