jiambalvo text book solutions (4)

Chapter 6Cost Allocation and Activity-Based Costing

QUESTIONS

1. Indirect costs are allocated to (1) provide information for decision making, (2) reducefrivolous use of common resources, (3) encourage evaluation of internally providedservices, and (4) calculate the “full cost” of products for GAAP reporting.

2. The statement is false. Cost allocation refers to the process of assigning indirect costs.Direct costs are traced to cost objects. Costs are allocated for a variety of reasons. It is noteconomically feasible to directly trace some costs to cost objects—these costs are classifiedas indirect costs and are allocated to the cost object via the use of an allocation base.

3. Charging for internal services can reduce frivolous use of resources and encouragedepartments being charged to critically evaluate the service. In addition, GAAP requiresthat all manufacturing costs be assigned to goods being produced. Thus, cost allocation ofindirect manufacturing costs is required.

4. Cost-plus contracts specify that the contractor will be paid for the cost of production (orservices) plus some fixed amount or percentage of cost. Defense contracts with the federalgovernment are often cost-plus contracts.

A major problem with cost-plus contracts is that they give the contractor an incentive toallocate as much cost as possible to the cost-plus contract (via the choice of an allocationbase) where it will be reimbursed.

5. A cost objective is a product, service, or department that receives an allocation of cost. Forexample, a production department that receives an allocation of janitorial cost is a costobjective. Likewise, a product in a department that receives an allocation of depreciation ofequipment is a cost objective.

6. A cost pool is a collection of individual indirect costs whose total is allocated using oneallocation base. Cost pools are often formed along department lines. For example, themaintenance cost pool would include all costs of the maintenance department.

7. A concern in forming a cost pool is that the costs within the cost pool be similar orhomogeneous. It is unlikely that variable and fixed costs are similar (i.e., that oneallocation base is suitable for allocating both fixed and variable costs). Homogeneous costpools provide more accurate information.

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8. Number of employees in a department would, most likely, result in a cause-and-effectallocation (at least for the variable costs in the cafeteria).

9. (1) Benefits received (relative benefits)(2) Ability to bear costs(3) Equity or fairness

10. If budgeted costs are allocated, then service departments cannot pass on inefficiencies andwaste. Allocating actual costs gives the service department little incentive to be efficient.

11. In a responsibility accounting system, revenues and costs are traced to departments/divisions and individuals with related responsibility for generating revenues and controllingcosts. This facilitates performance evaluation of managers and the operations under theircontrol.

12. Sometimes managers are allocated costs beyond their control in order to make them awarethat the cost exist and must be covered by revenues of the firm.

13. Unitizing fixed costs make them appear to be variable. If the unitized fixed costs are thenallocated to divisions based on, for example, revenue, divisional managers may makedecisions in order to maximize divisional profits that are not in the company’s best interest.This problem can be avoided by lump-sum allocations of fixed costs.

14. Traditional allocation methods use a small number of cost pools and allocation basesrelated to production volume. However, some costly activities are not related to productionvolume. Consider the costs associated with setups—in a traditional costing system setupcosts would be allocated based on production volume and high volume products willreceive most of the allocated cost even though low volume products may require an equalnumber of setups.

15. The traditional costing approach typically uses allocation bases that are measures ofproduction volume (e.g., direct labor hours, direct labor cost, or machine hours). Also, fewcost pools are used under the traditional approach (e.g., one or two cost pools).

ABC focuses on major activities that cause overhead costs to be incurred. Many of theseactivities are not related to production volume. Cost pools are formed for each majoractivity and costs are assigned to products using an allocation base that is a cost driver.Many of the cost drivers are not related to production volume. ABC typically uses morecost pools and related cost drivers.

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16. ABC will tend to give more accurate costs than a traditional cost system when:(1) the production process is complex and varied (high and low volume products),(2) products consume resources differently, and(3) there are activities that are not related to production volume (e.g., setups).

17. (1) ABC is more costly to develop and maintain than a traditional system.(2) In practice, ABC is used to develop the full cost of products. The ABC cost per unitdoes not measure the incremental costs needed to produce an item. Therefore, it is notalways useful for decision making.

18. ABC focuses on activities with the goal of measuring costs of products and servicesproduced by the firm. ABM focuses on activities with the goal of managing the activitiesthemselves. ABC has the goal of accurately computing costs of products and services whileABM focuses on reducing the costs of or the demand for major activities.


EXERCISES

E1. Fixed costs (e.g., administrative costs) are sometimes allocated based on ameasure of business activity (e.g., sales). This makes the costs appear to bevariable (e.g., the higher sales, the higher the allocation of administrativecost). In turn, this may lead to poor decisions if managers treat the allocatedcosts as incremental.

E2. This allocation is potentially harmful. A hotel manager will tend tooverestimate the costs that increase with revenue. And this may lead to poordecisions that affect revenue. For example, suppose a hotel manager isconsidering a trade association’s request for a special convention rate of $70per room during a slow season. The manager estimates that variable costs perroom are $75 including $10 of allocated costs for general administration. Inthis case, the manager will turn down the request even though his or hercompany would really make $5 of incremental profit per room. Remember,$10 of allocated costs appear variable but, in fact, are fixed. Thus, actualincremental costs are only $65, which is $5 less than incremental revenue of$70.

E3. According to Table 1 displayed at this Web site, building depreciation isallocated based on square footage, telecommunications costs are allocatedbased on number of phone numbers (referred to as direct telephone ID), andadministrative and general costs are allocated based on a unit’s total expenseas a percent of the total expense of all units.

These allocations are not “cause and effect” allocations. Consider buildingdepreciation. When a unit occupies space, it doesn’t cause cost equal toallocated depreciation. It may be that the space wasn’t occupied, in whichcase no cost was caused. Or, occupancy may have led to a need to rentadditional space, causing a cost much higher than allocated depreciation.Rather, the allocations are based on “relative benefit.” Thus, for example, ifyou occupied space you benefited! And the assumption is that your benefitwas proportionate to space occupied.

E4. Star might want to encourage department managers to evaluate securityservices. When security costs are allocated, departments have an incentive to


voice concerns about the cost of security service. This may make the securitydepartment more efficient. In addition, allocation of security costs that relateto manufacturing are required under GAAP.

E5. a. Service Department Allocation BaseHuman resources Number of employeesDuplicating Number of pages copiedJanitorial Floor spaceAccounting Number of sales transactionsGraphic design Time spent on design workFood services Number of employees

b. Under the direct method costs are not allocated between servicedepartments. Thus, the Human Resource department would not receive ashare of Food Services costs.

E6. Total fixed costs to be allocated = $60,000 + 15,000 + 15,000 + 2,000 =$92,000.

Fixed costs allocated to Sales ($92,000 × .3) $ 27,600Variable costs allocated to Sales (1,500,000 copies × $.02) 30,000Total costs allocated to Sales $ 57,600

Fixed costs allocated to Admin. ($92,000 × .7) $ 64,400Variable costs allocated to Admin (2,500,000 copies × $.02) 50,000Total costs allocated to Sales $114,400

E7. Allocation Base Prod. Dept.1 Prod. Dept.2

Square footage $1,200,000 $1,800,000

Direct labor hrs. $1,800,000 $1,200,000

(1) As indicated, the choice of the allocation base greatly affects theallocations of cost. Use of square footage as the allocation base assigns 60%of the cost to department 2 and 40% to department 1. However, use of directlabor hours allocates 60% of the cost to department 1 and only 40% to


department 2. Department 1 would prefer to be allocated cost based on squarefootage and department 2 would prefer direct labor hours as the base.

(2) An allocation base that results in a cause and effect allocation is preferred.If maintenance costs are mostly related to building maintenance, then squarefootage is more likely to result in a cause and effect allocation. However, ifmaintenance costs are mostly made up of machine maintenance, then machinehours might be a better allocation base.

E8. P1 has 150/375 = 40% of production department employees.P2 has 225/375 = 60% of production department employees.

Service Service dept. Cost Allocated toDepartment Costs P1 P2 S1 $3,000,000 $1,200,000 $1,800,000S2 2,000,000 800,000 1,200,000S3 1,000,000 400,000 600,000Total cost $6,000,000 $2,400,000 $3,600,000

E9. a. The manufacturing overhead allocation includes $52 of fixed cost whichwill not increase if the special order is accepted (i.e., it is not anincremental cost). The incremental revenue and incremental costsassociated with the order suggests that the company will be better off by$45,000 if the order is accepted.

Incremental revenue (1,000 × $175) $175,000Incremental costs Material (1,000 × $80) 80,000 Labor (1,000 × $40) 40,000 Variable overhead (($1,000 × $10) 10,000 130,000Incremental profit $ 45,000

b. Managers who focus on reported cost may (incorrectly) treat the $52 offixed cost as an incremental cost. In this case they will (incorrectly)conclude that the order should not be accepted because the total cost($182) is greater than the offer ($175).


E10. a. The reason that allocated general and administrative costs are higher forthe Services Department is that revenue in the Sales Department hasdecreased. Since general and administrative costs are allocated based onactual revenues, changes in one department’s revenue affects anotherdepartment’s allocation of overhead costs (since it has a higherproportion of total revenue).

b. If accounting department costs are affected by Rex Kerr’s decisions, thenhe should be held responsible for those costs. However, it appears thathis department is being allocated costs over which he has no control.Allocating cost beyond Kerr’s control may cause him to feel that he hasbeen treated unfairly, especially if his performance is based on theservice department’s profits.

E11. a. The manager of Keller Auto Insurance will perceive that allocated servicedepartment costs are variable cost (when auto insurance revenueincreases, the allocated costs increase).

b. In performing incremental analysis, the president of Keller AutoInsurance will tend to overestimate incremental costs because he or shewill treat allocated costs as incremental costs (when some of the costsare, in all likelihood, fixed).


E12.a. The use of a single cost pool causes A1 to be undercosted and B1 to beovercosted. With a single cost pool, both products receive the sameallocation of cost per labor hour. However, A1 uses relatively more timein P1 where overhead costs are high while B1 uses relatively more timein P2 where overhead costs are low.

The one-cost pool overhead rate is:$3,000,000 ÷ 400,000 DLH = $7.50 /DLH

Each product requires 5 direct labor hours in total. Therefore, each will beallocated $37.50 in overhead costs ($7.50 × 5) Now let’s calculate the amount of overhead allocated to each product if Mottused a separate overhead cost pool for each production department.

P1’s overhead rate will be $2,000,000 ÷ 100,000 DLH = $20.00 per directlabor hour.P2’s overhead rate will be $1,000,000 ÷ 300,000 DLH = $3.33 per directlabor hour.

Overhead allocated to each unit of A1 will be: (2 labor hours × $20) + (3 labor hours × $3.33) $49.99Overhead allocated to each unit of B1 will be: (1 labor hour × $20) + (4 labor hours × $3.33) $33.32

Note that the overhead allocated to B1 is lower with two cost pools while theallocation to A1 is higher.

E13. a. If the costs of the design department are fixed and the department is ableto complete jobs on a timely basis, then the opportunity cost of using thedepartment is approximately zero and equal to the allocation (which isalso zero).

b. Subsidiaries often have to go outside for design work because of timedelays. Thus, there is an opportunity cost associated with use that isgreater than the allocation (which is zero).

c. The allocation of $50 per hour must be less than the opportunity cost(subsidiaries are willing to pay $70 per hour to avoid delays). Thus, theymust have a benefit that exceeds $70.


d. The opportunity cost of using design services may be less than $50 sinceno one is being turned away or delayed. Thus, there does not appear to bea benefit foregone because of use.

E14. COST POOL COST DRIVERInspection of raw materials Number of receiptsProduction equipment repairs and maintenance Machine hoursRaw materials storage Dollar value of raw materialsPlant heat, light, water, and power Square footageFinished product quality control Number of inspectionsProduction line setups Number of setups

E15. Cost per setup = $1,500,000 ÷ 1,000 = $1,500

Cost of setups related to EP150 = 2 × $1,500 = $3,000

Setup cost per unit of EP150 = $3,000 ÷ 750 = $4

E16. If the cost to process an order is much higher at one plant than at the otherand the orders are similar, then there is a good chance that the costs are outof control at the higher cost location and a manager should investigate thesituation. Conceivably, the company can adopt “best practices” from thelow cost plant.

E17. a. The cost of filling orders at PorcheParts.com is:($250,000 + $300,000) ÷ 100,000 = $5.50 per order.

The cost of filling orders at the auto supply chain is only $4 per hour.While this is lower, it may be that that, due to its size, the auto supplychain has a “state of the art” warehouse. It may be unrealistic forPorcheParts.com, which is relatively small, to compare itself to such alarge company.

b. Possibly, order “pickers” can take multiple order sheets out to thewarehouse when individual orders are small. This will save considerabletime going back and forth to the warehouse and may lead to lower costsif the company is willing to fire or reassign one or more of the fiveworkers who pick parts.


PROBLEMS

P1. a. Allocation Base Software ConsultingEmployee benefits Head count 300 100

Proportion .75 .25Amount allocated $1,000,000 $750,000 $250,000

Rent Square feet 15,000 15,000Proportion .5 .5Amount allocated $600,000 $300,000 $300,000

Telecommunications Headcount 300 100Proportion .75 .25Amount allocated $400,000 $300,000 $100,000

General and adm. costs Sales $10,000,000 $5,000,000Proportion .666667 .333333Amount allocated $2,000,000 $ 1,333,334 $ 666,666Total $4,000,000 $ 2,683,334 $1,316,666

Profit Report: (using multiple cost pools/allocation bases)

Software ConsultingSales $10,000,000 $5,000,000Less direct costs 5,000,000 3,000,000Less allocated costs 2,683,334 1,316,666Income before taxes $ 2,316,666 $ 683,334

Using multiple cost pools and multiple allocation bases allocates $316,666more overhead cost to consulting than a single allocation base method.

b. Assuming the controller’s assumptions are correct (that benefits andtelecommunications costs are driven by headcount while rent is driven byspace occupied and general and administrative costs are driven by relativesales), then the multiple cost pools provide better information on the resourcesconsumed and the profitability of the two divisions.


P2. a. The opportunity cost of producing a Model 350 motor is simply theincremental cost of production (given that Binder has excess capacity andsales to Dacon will not affect sales to other customers).

Direct material $20Direct labor 10Variable overhead ($.80 × direct labor)* 8

Total $38* Variable overhead rate is equal to $4,000,000 of variable overhead ÷$5,000,000 of direct labor.

b. Since 60 percent of the overhead is fixed ($12 per motor), the incremental costto produce the motors is $38 per motor ($20 + 10 + 8). Any bid greater than$38 (that’s accepted) will generate incremental profit. If Binder can get theorder with a bid of $48, the company should bid this amount. It will generateincremental profit of $50,000 [($48 - $38) × 5,000 motors].

c. The opportunity cost related to overhead, in this case, is simply the variableoverhead amount. An allocation based on the opportunity cost idea, helpsmanagers focus on incremental costs—the information needed for decisionmaking.


P3. a. Overhead rate based on direct-labor dollars($50,000,000 overhead ÷ $5,000,000 labor) $10 per dollar of labor

Overhead rate based on machine hours($50,000,000 overhead ÷ 500,000 machine hours) $100 per machine hour

Civilian Military Labor$ Mach.Hrs. Labor$ Mach.Hrs .

Direct material $2,000 $ 2,000 $ 2,500 $ 2,500Direct labor 600 600 900 900Overhead 6,000 8,000 9,000 8,000Cost $8,600 $10,600 $12,400 $11,400

b. The price charged for the civilian version of the Model KV10 does notdepend on allocated costs. However, the military version is sold for “cost”plus 10 percent of cost. Therefore, the company has an incentive to makecost appear higher rather than lower. This can be accomplished byallocating overhead cost using direct labor cost as the allocation base. Thisbase results in a higher cost ($12,400) compared to an allocation based onmachine hours which results in a cost of only $11,400.

c. Many, if not most, managers believe that “it is well known that allocationis somewhat arbitrary and the government is not at all surprised thatcompanies pick allocation bases to maximize their profit.” Since no one isbeing “fooled,” the behavior is not illegal, and the “right” allocation isn’tobvious, picking an allocation base to maximize profit does not appear tobe unethical.


P4. a. Twenty percent of air miles are by Domestic (5,000,000 miles ÷25,000,000 miles) and International flights accounts for 80 percent of thetotal air miles. Therefore, Domestic flights will be allocated 20 percent ofthe service departments’ costs and International will be allocated 80percent.

Allocated to Costs Domestic International

Ticketing $ 4,000,000 $ 800,000 $3,200,000Baggage handling 2,000,000 400,000 1,600,000Maintenance 6,000,000 1,200,000 4,800,000 Total $12,000,000 $2,400,000 $9,600,000

b. The best cause-and-effect relation is probably between maintenance costsand air miles flown (the most suspect relation is between ticketing and airmiles flown—more miles do not lead to higher ticketing costs). Given thatinternational passengers have more baggage and have more transfers thandomestic flyers, the relation between baggage handling costs and air milesflown is probably stronger than the relation between air miles and ticketingbut weaker than the relation between air miles and maintenance.

A better allocation base for ticketing might be number of tickets issued. Abetter allocation base for baggage handling might be number of bagshandled.

P5. Production department use of serviceService depts. Assembly TestingMaintenance ($400,000) 70% 30%Computing ($600,000) 33.33% 66.67%

Service dept. costs allocated to Assembly: (.7 × $400,000) + (.3333 × $600,000) = $280,000 + 200,000 = $480,000.Service dept. costs allocated to Testing: (.3 × $400,000) + (.6667 × $600,000) = $120,000 + 400,000 = $520,000.


P6. a.Allocation Base Financial Planning Business Consulting

Proportion Amount Proportion AmountSalaries .667 $666,667 .333 $333,333Headcount .750 $750,000 .250 $250,000

b. Both headcount and salary appear to be plausible allocation bases, but theyresult in very different allocations. This suggests that in many casesallocations are somewhat arbitrary.

P7. a. Old overhead rate $10 per labor hourCurrent overhead rate

($2,400,000 ÷ 150,000 direct labor hours) $16 per labor hour

Current overhead cost allocated to an 8 labor-hour job: ($16 × 8 labor hours) $128

Prior year overhead allocated to an 8 labor-hour job($10 × 8 labor hours) $80

The current overhead cost for an 8 labor-hour job is 60% more than the prioroverhead cost.

b. Small jobs in the current year appear to be less profitable compared to theprior year. This is because they are allocated overhead costs as if theyrequired use of the new equipment. Therefore, small jobs will beovercosted. In all likelihood, the jobs do not really cost more than they didin the prior year. One way to avoid miscosting of small (labor-intensive)jobs would be to develop a separate overhead allocation rate for jobs thatare labor intensive and do not make use of the new equipment.


P8. a. The recreation kayaks are uniform and probably made in large batches. Thecompetition kayaks are custom made one at a time. Several costs in theoverhead cost pool are probably less expensive on a per unit bases forrecreation versus competition kayaks. For example, each competition kayakprobably requires (on average) more equipment time, quality control, andsetup and drafting costs compared to each recreation kayak.

b. Summit needs to look at the costs of activities that each line of kayaksrequires. Summit could get more accurate costs if each of the majoroverhead cost components were allocated to the kayak line using anappropriate cost driver.

c.Cost Pool Cost Recreation Competition

use of base allocation use of base allocationBuilding $ 25,000 .857 $ 21,429 .143 $ 3,571Equipment 25,000 .850 21,250 .150 3,750Materials ordering 15,000 .667 10,000 .333 5,000Quality control 10,000 .667 6,667 .333 3,333Maintenance & security 10,000 .857 8,571 .143 1,429Set up and drafting 20,000 .333 6,667 .667 13,333Supervision 30,000 .900 27,000 .100 3,000Total $135,000 $101,584 $33,416Per kayak $112.87 $334.16

Total unit costs for each model boat:

Recreation CompetitionDirect materials $150.00 200.00Direct labor 100.00 100.00Overhead 112.87 334.16Total unit cost 362.87 634.16Sales price 600.00 660.00Gross Profit $237.13 $ 25.84


d. The traditional allocation method used by Summit is essentially a volume-based method. In this problem, each unit of the competition kayak used thesame amount of direct labor as a recreation kayak, but required much more ofsome overhead resources. For example, total competition kayaks accountedfor 10 percent of volume and required 10 percent of direct labor but needed66.7 percent of set up and drafting resources. Using a single traditionalallocation base assumes that each product uses all overhead resources in thesame proportion that the allocation base is used. Except for supervision,competition kayaks use more than 10 percent of overhead resources. Betterinformation will be provided by an ABC system. With an ABC system, costpools will be formed for key activities and overhead drivers (allocation bases)need not be based on production volume.

P9. a.Cost Pool Overhead rateMaterials ordering $800,000 ÷ 100,000 = $8.00 / orderMaterials inspection $400,000 ÷ 2,000 = $200 / rec. reportEquipment setup $2,000,000 ÷ 100 = $20,000 / setupQuality control $900,000 ÷ 4,000 = $225 / inspectionOther $15,000,000 ÷ $10,000,000 = $1.50 / labor cost

b. Materials ordering $8.00 per order × 1,000 orders = $ 8,000Materials inspection $200 per report × 300 reports = 60,000Equipment setup $20,000 per setup × 1 setups = 20,000Quality control $225 per inspection × 400 inspections = 90,000Other $1.50 per labor dollar × $120,000 = 180,000

Total overhead assigned to Remote Mouse $358,000

c. Overhead rate per unit of Remote Mouse = $358,000 ÷ 20,000 units =$17.90

d. Total unit costs per unit of Remote Mouse = $31 + $6 + $17.90 = $54.90

e. With a traditional system:The overhead rate per direct labor dollar is:

($19,100,000 ÷ $10,000,000 direct labor cost) $1.91 per dollar of direct labor


The direct labor cost, per unit, for the Remote Mouse: ($120,000 ÷ 20,000 units) $6.00

Overhead assigned to each unit of Remote Mouse ($1.91 × $6.00 direct labor cost) $11.46

ABC assigns $6.44 more overhead to each unit of Remote Mouse than isassigned using a traditional production volume base. Remote Mouseproduction uses only 1.2 percent of direct labor dollars, but requires 10percent of materials ordering, 15 percent of materials inspection, and 10percent of quality control resources. Remote Mouse production uses arelatively a small amount of direct labor dollars and is therefore undercosted atraditional approach to allocation.

P10. a. Cost to book travel (per completed trip):$800,000 ÷ 20,000 completed trips = $40 per completed trip

The benchmark cost is $30 per completed trip. Thus, it appears thatBaxter’s costs are relatively high (33% more than the benchmark), andprocess improvement is warranted.

b. The wages paid to employees who book travel are $630,000 (14 employees× $45,000.

Number of completed trips booked: 1,000 consultants × 20 trips 20,000 trips

Number of trips booked but not necessarily completed: 1.30 × 20,000 26,000 trips

Bookings not completed 6,000 trips

Wage cost per trip booked but not necessarily completed: $630,000 ÷ 26,000 $24.23

Wage cost of trips not completed: 6,000 × $24.23 $145,380.00

Savings if number can be reduced by 50 percent: $145,380 × .5 $72,690.00


P11. a. A sophisticated Web site and call center can reduce demands placed ontellers to process deposits, process withdrawals, deal with requests forCDs, answer questions related to balances, and respond to requests forstatements. A sophisticated Web site or call center will not impact tellertime to provide access to safe deposit boxes or reconcile the cash drawer.

b. A sophisticated Web site, automatic cash machines, and call centersoftware that provides responses to common questions are examples oftechnology that can reduce the cost of services provided by tellers.

P12. With 6,000 employees and turnover of 15%, 900 people leave the companyand 900 are added to take their place each year (.15 x 6,000). With this inmind, having 6 employees to handle new employee training appearsexcessive. Suppose each new employee requires a half day of training. Thatimplies 450 training days. Assume that each trainer works 5 days per weekfor 48 weeks per year. Then, each trainer covers 240 training days. Thus,only 2 trainers are needed (450 ÷ 240 = 1.875). Reducing trainers by 4 wouldsave $20,000 in salary each month.

Now, consider operations. It’s not clear that 5 clerks are needed. Supposepaperwork related to resignations and new hires is 2 hours per person. Thisimplies a need for 3,600 hours (2 hours x 1,800 resignations or hires).Assuming each clerk works 8 hours per day, with a 5 day work week for 48weeks, a clerk has 1,920 hours. Again, it appears that only 2 clerks areneeded (3,600 ÷ 1,920 = 1.875). A reduction of 3 clerks would save $7,500per month.

Based on the above analysis, which admittedly required some “ballpark”assumptions, the low hanging fruit is in operations and training.

Note that the total savings is estimated to be $27,500 per month or $330,000per year. Assuming the ABM study reduced waste for 3 years, the companywould save approximately $1,000,000. If similar savings could be found inother departments, ABM would create substantial shareholder value.