CHAPTER 4 Cost Accumulation, Tracing, and Allocation LEARNING OBJECTIVES LO 4-4 G A Identify cost objects and distinguish between direct costs versus indirect costs. T Allocate indirect costs to cost objects. E Identify the most appropriate cost driver. S Allocate joint costs to joint products. , LO 4-5 Recognize the effects of cost allocation on employee motivation. LO 4-6 Allocate service department costsDto operating departments (Appendix). After you have mastered the material in this chapter, you will be able to: LO 4-1 LO 4-2 LO 4-3 E Video lectures and accompanying self-assessment quizzes are available in Connect® A for all learning objectives. CHAPTER OPENING N D R A What does it cost? This is1one of the questions most frequently asked by business managers. 1 cost estimates to price products, evaluate performance, control Managers must have reliable 2 3 know the cost of many different things. The things we are trying to determine the cost of are T commonly called cost objects. S For example, if we are trying to determine the cost of operating operations, and prepare financial statements. As this discussion implies, managers need to a department, that department is the cost object. Cost objects may be products, processes, departments, services, activities, and so on. This chapter explains techniques managerial accountants use to determine the cost of a variety of cost objects. The Curious Accountant A former patient of a California hospital complained about being charged $7 for a single aspirin tablet. After all, an entire bottle of 100 aspirins can beG purchased at the local pharmacy store for around $2. A Can you think of any reasons, other than shameT less profiteering, that a hospital would need to E charge $7 for an aspirin? Remember that the hospiS tal is not just selling the aspirin; it is also delivering it , to the patient. (Answers on page 166.) D E A N D R A 1 1 2 3 T S © Stockbyte/PunchStock 158 Chapter 4 DETERMINE THE COST OF COST OBJECTS LO 4-1 Identify cost objects and distinguish between direct costs versus indirect costs. © Kevin Fleming/Corbis Accountants use cost accumulation to determine the cost of a particular object. Suppose the Atlanta Braves advertising manager wants to promote a Tuesday night ball game by offering free baseball caps to all children who attend. What would be the promotion cost? The team’s accountant must accumulate many individual costs and add them together. For simplicity, consider only three cost components: (1) the cost of the caps, (2) the cost of advertising the promotion, and (3) the cost of an employee to work on the promotion. 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. Determining the costs of the secondary cost objects requires identifying what drives those costs. A cost driver has a cause-and-effect relationship with a cost object. For example, the number of caps (cost driver) has an effect on the cost of caps (cost object). The number of advertisements is a cost G driver for the advertising cost (cost object); the number of laA bor hours worked is a cost driver for the labor cost (cost obT ject). Using the following assumptions about unit costs and cost drivers, the accumulated cost of the primary cost object (cost of E the cap promotion) is: Cost Object S , Cost per Unit × Cost Driver = Cost of caps $   2.50 × 4,000 caps = Cost of advertising $100.00 × 50 advertisements = D $   8.00 Cost of labor × 100 hours = Cost of cap promotion E Total Cost of Object $10,000 5,000 800 $15,800 A The Atlanta Braves N should run the promotion if management expects it to produce additional revenues exceeding $15,800. D R Estimated versus Actual Cost Athe promotion—$15,800—is an estimate. Management cannot The accumulated cost of know actual costs and revenues until after running the promotion. While actual information is more accurate, it is not relevant for deciding whether to run the promotion because the 1 the actual cost is known. Managers must accept a degree of decision must be made before inaccuracy in exchange for 1 the relevance of timely information. Many business decisions are based on estimated rather than actual costs. 2 Managers use cost estimates to set prices, bid on contracts, evaluate proposals, distribute 3 and set goals. Certain circumstances, however, require actual cost resources, plan production, data. For example, published T financial reports and managerial performance evaluations use actual cost data. Managers frequently accumulate both estimated and actual cost data for the same cost object. For example, S companies use cost estimates to establish goals and use actual costs to evaluate management performance in meeting those goals. The following discussion provides a number of business examples that use estimated data, actual data, or a combination of both. Assignment of Costs to Objects in a Retail Business Exhibit 4.1 displays the January income statement for In Style, Inc. (ISI), a retail ­clothing store. ISI subdivides its operations into women’s, men’s, and children’s departments. To encourage the departmental managers to maximize sales, ISI began paying Cost Accumulation, Tracing, and Allocation the manager of each department a bonus based on a percentage of departmental sales revenue. Although the bonus incentive increased sales revenue, it also provoked negative consequences. The departmental managers began to argue over floor space; each manager wanted more space to display merchandise. The managers reduced prices; they increased sales commissions. In the drive to maximize sales, the managers ignored the need to control costs. To improve the situation, the store manager decided to base future bonuses on each department’s contribution to profitability rather than its sales revenue. Identifying Direct and Indirect Costs 159 EXHIBIT 4.1 Income Statement IN STYLE, INC. Income Statement For the Month Ended January 31 Sales Cost of goods sold Gross margin Sales commissions Dept. managers’ salaries Store manager’s salary Depreciation Rental fee for store Utilities Advertising Supplies Net income The new bonus strategy requires determining the cost of operating each department. Each department is a separate cost object. 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/ G benefit analysis. A Some of ISI’s costs can be easily traced to the cost T sold is an ­objects (specific departments). The cost of goods example of an easily traced cost. Price tags on merchandise can be coded so cash register E scanners capture the departmental code for each sale. The cost of goods sold is not only easily traceable but also very useful information.SCompanies need cost of goods sold information for financial reporting (income statement , and balance sheet) and for management decisions (determining inventory reorder points, pricing strategies, and cost control). Because the cost of tracing cost of goods sold is small relative to the benefits obtained, cost of goods sold is a direct cost. D In contrast, the cost of supplies (shopping bags, sales slips, pens, staples, price tags) used by each department is much more difficult toEtrace. How could the number of staples used to seal shopping bags be traced to any particular A department? The sales staff could count the number of staples used, but doing so would be silly for the benefits obtained. N Although tracing the cost of supplies to each department may be possible, it is not worth the effort of doing so. The cost of supplies is therefore an indirect cost. Indirect costs are D also called overhead costs. R Direct and indirect costs can be described as follows: A Direct costs can be traced to cost objects in a cost-effective manner. Indirect costs cannot be traced to objects1in a cost-effective manner. 1 2 By analyzing the accounting records, ISI’s accountant classified the costs from the 3 as shown in Exhibit 4.2. The next ­income statement in Exhibit 4.1 as direct or indirect, ­paragraph explains the classifications. T All figures represent January costs. Items 1 though 4 are direct costs, traceable to the S sold is traced to departments at the cost objects in a cost-effective manner. Cost of goods point of sale using cash register scanners. Sales commissions are based on a percentage of departmental sales and are therefore easy to trace to the departments. Departmental managers’ salaries are also easily traceable to the departments. Equipment, furniture, and fixtures are tagged with department codes that permit tracing depreciation charges directly to specific departments. Items 5 through 8 are incurred on behalf of the company as a whole and are therefore not directly traceable to a specific department. Although Item 9 could be traced to specific departments, the cost of doing so would exceed the benefits. The cost of supplies is therefore also classified as indirect. $ 360,000 (216,000) 144,000 (18,000) (12,000) (9,360) (16,000) (18,400) (2,300) (7,200) (900) $ 59,840 160 Chapter 4 EXHIBIT 4.2 Income Statement Classification of Costs Direct Costs Indirect Cost Item Women’s Men’s Children’s Costs 1. Cost of goods sold—$216,000 $120,000 $58,000 $38,000 2. Sales commissions—$18,000 9,500 5,500 3,000 3. Dept. managers’ salaries—$12,000 5,000 4,200 2,800 4. Depreciation—$16,000 7,000 5,000 4,000 5. Store manager’s salary 6. Rental fee for store 7. Utilities 8. Advertising 9. Supplies Totals $141,500 $72,700 $47,800 $ 9,360 18,400 2,300 7,200 900 $38,160 G A Cost Classifications—Independent and Context Sensitive T Whether a cost is direct or indirect is independent of whether it is fixed or variable. In the ISI example, both cost ofEgoods 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. S Furthermore, the cost of rent and the cost of depreciation are both fixed relative to sales , is indirect and the cost of depreciation is direct. In fact, the very volume, but the cost of rent same cost can be classified as direct or indirect, depending on the cost object. The store manager’s salary is not directly traceable to a specific department, but it is traceable to a particular store. As theseDexamples demonstrate, cost classification depends on the context in which the costs occur.E LO 4-2 Allocate indirect costs to cost objects. A N ALLOCATING INDIRECT COSTS TO OBJECTS D Common costs support R multiple cost objects but cannot be directly traced to any specific object. In the case of In Style, Inc., the cost of renting the store (common cost) supports the A departments (cost objects). The departmental managers may women’s, men’s, and children’s shirk responsibility for the rental cost by claiming that others higher up the chain of command are responsible. Responsibility can be motivated at the departmental level by assigning (allocating) a portion1of the total rental cost to each department. To accomplish appropriate motivation, authority must accompany responsibility. In 1 other words, the departmental managers should be held responsible for a portion of 2 rental cost only if they are able to exercise some degree of control over that cost. For 3 assigned a certain amount of the rental cost for each square example, if managers are foot of space they use, T they should have the authority to establish the size of the space used by their departments. Controllable costs are costs that can be influenced by a manager’s decisions andSactions. The controllability concept is discussed in more detail in Chapter 9. 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, there is a cause-and-effect relationship between store size and rent cost; the larger the building, the higher the rent cost. This relationship suggests that the more floor space a department ­occupies, the more rent cost that department should bear. To illustrate, assume ISI’s store Cost Accumulation, Tracing, and Allocation 161 REALITY BYTES How does Southwest Airlines know the cost of flying a passenger from Houston, Texas, to Los Angeles, California? The fact is that Southwest does not know the actual cost of flying particular passengers anywhere. There are many indirect costs associated with flying passengers. Some of these include the cost of planes, fuel, pilots, office buildings, and ground personnel. Indeed, besides insignificant food and beverage costs, there are few costs that could be traced directly to customers. Southwest and other airlines are forced to use allocation and averaging to determine the estimated cost of providing transportation services to customers. Estimated rather than actual cost is used for decision-­ making purposes. Consider that in its 2014 annual report Southwest reported the ­average operating expenses of flying one passenger one mile (called a passenger mile) were 12.5¢. However, this number was based on 130 billion “available passenger miles.” In 2014, Southwest operated at © iStock.com/rypson 82.5 percent of capacity, not 100 percent, so it was able to charge passengers only for 107.3 billion passenger miles. Thus, its average G operating expenses were closer to 15.2¢ for each mile for which it was able to charge. Had it operated at a higher capacity, its average costs would have been lower. A T E and children’s departments occupy capacity is 23,000 square feet and the women’s, men’s, 12,000, 7,000, and 4,000 square feet, respectively. ISI S can achieve a rational allocation of the rent cost using the following two-step process.1 , Step 1. Compute the allocation rate by dividing the total cost to be allocated ($18,400 rental fee) by the cost driver (23,000 square feet of store space). The cost driver is D also called the allocation base. This computation produces the allocation rate, as follows: E Total cost to be allocated ÷ Cost driver (allocation base) = Allocation rate A $18,400 rental fee Step 2. ÷ 23,000 square N feet = D $0.80 per square foot Multiply the allocation rate by the weight of the cost driver (weight of the base) R as follows: to determine the allocation per cost object, A Cost Object Allocation Rate × Number of Square = 1 Feet Allocation per Cost Object 1 12,000 Women’s department $0.80 × = $ 9,600 Men’s department 0.80 × 7,000 = 5,600 2 4,000 Children’s department 0.80 × = 3,200 3 23,000 $18,400 Total T S It is also plausible to presume utilities cost is related to the amount of floor space a d­ epartment occupies. Larger departments will consume more heating, lighting, air ­conditioning, and so on than smaller departments. Floor space is a reasonable cost driver Other mathematical approaches achieve the same result. This text consistently uses the two-step method described here. Specifically, the text determines allocations by (1) computing a rate and (2) multiplying the rate by the weight of the base (cost driver). 1 162 Chapter 4 for utility cost. Based on square footage, ISI can allocate utility cost to each department as follows: Step 1. Compute the allocation rate by dividing the total cost to be allocated ($2,300 utility cost) by the cost driver (23,000 square feet of store space): Total cost to be allocated ÷ $2,300 utility cost Step 2. Cost driver = Allocation rate ÷ 23,000 square feet = $0.10 per square foot Multiply the allocation rate by the weight of the cost driver to determine the ­allocation per cost object: Cost Object Allocation Rate × Number of Square Feet = Allocation per Cost Object Women’s department $0.10 × 12,000 = $1,200 Men’s department 0.10 × 7,000 = 700 Children’s department 0.10 × 4,000 = 400 Total 23,000 $2,300 G A T CHECK YOURSELF 4.1 E HealthCare, Inc. wants to estimate the cost of operating the three departments (Dermatology, S that serve patients in its Health Center. Each department performed ­Gynecology, and Pediatrics) the following number of patient treatments during the most recent year of operation: Dermatol, ogy, 2,600; Gynecology, 3,500; and Pediatrics, 6,200. The annual salary of the Health Center’s program administrator is $172,200. How much of the salary cost should HealthCare allocate to the Pediatrics Department? D Answer E A Total cost to be allocated ÷ Cost driver (patient treatments) = Allocation rate N $172,200 salary cost ÷ (2,600 + 3,500 + 6,200) = $14 per patient treatment D Step 2. Multiply the allocation R rate by the weight of the cost driver (weight of the base) to determine the allocation per cost object. A Step 1. Compute the allocation rate. Cost Object Allocation Rate × No. of Treatments = Allocation per Cost Object 1 Pediatrics department 1 $14 × 6,200 = $86,800 2 3 T to Be Allocated Using Cost Pools Determining the Cost S single indirect cost a company incurs would be tedious and not Allocating individually every particularly 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, a company may accumulate costs for gas, water, electricity, and telephone service into a single utilities cost pool. It would then allocate the total cost in the utilities cost pool to the cost objects rather than individually allocating each of the four types of utility costs. How far should pooling costs go? Why not pool utility costs with indirect labor costs? If the forces driving the utility costs are different from the forces driving the labor costs, Cost Accumulation, Tracing, and Allocation 163 p­ ooling the costs will likely reduce the reliability of any associated cost allocations. To ­promote accuracy, pooling should be limited to costs with common cost drivers. Costs that have been pooled for one purpose may require disaggregation for a different purpose. Suppose all overhead costs are pooled for the purpose of determining the cost of making a product. Further, suppose that making the product requires two processes that are performed in different departments. A cutting department makes heavy use of machinery to cut raw materials into product parts. An assembly department uses human labor to assemble the parts into a finished product. Now suppose the objective changes from determining the cost of making the product to determining the cost of ­operating each department. Under these circumstances, it may be necessary to disaggregate the total overhead cost into smaller pools such as a utility cost pool, an indirect labor cost pool, and so on so that different drivers can be used to allocate these costs to the two departments. SELECTING THE COST DRIVER Companies can frequently identify more than one cost driver for a particular indirect cost. For example, ISI’s cost of shopping bags G provided to customers can be linked to both the number of sales transactions and the total A amount of sales. More specifically, since the store normally uses at least one shopping bag each time a sales transaction ­occurs, the number of sales transactions drives T the cost of shopping bags. Likewise, a $500 sales transaction is likely to require the company to provide more shopping bags E to a customer than would a $100 sales transaction. Therefore, the total amount of sales S scenario, should ISI use the number also drives the use of shopping bags. Given this of sales transactions or the total amount of sales , as the driver of the cost of shopping bags? The answer is, ISI should use the driver with the strongest cause-and-­ effect relationship. D E Cause and Effect versus Availability of Information A To illustrate, consider shopping bag usage for T-shirts sold in the children’s department versus T-shirts sold in the men’s department. AssumeNISI studied T-shirt sales during the first week of June and found the following: D R Department Children’s Men’s A Number of sales transactions Amount of total sales 120 $1,440 92 $1,612 1 1 Given that every sales transaction uses a shopping bag, the children’s department 2 uses far more shopping bags than the men’s department (120 versus 92) even though it has a lower amount of total sales ($1,440 versus3$1,612). A reasonable explanation for this circumstance is that children’s T-shirts sell for less than men’s T-shirts. The number T of sales transactions is the better cost driver because it has a stronger cause-and-effect relationship with shopping bag usage than doesSthe amount of sales. Should ISI there- fore use the number of sales transactions to allocate supply cost to the departments? Not ­necessarily. The availability of information also influences cost driver selection. While the number of sales transactions is the more accurate cost driver, ISI could not use this allocation base unless it maintains records of the number of sales transactions per department. If the store tracks the amount of sales but not the number of transactions, it must use the amount of sales even if the number of transactions is the better cost driver. For ISI, total sales appears to be the best available cost driver for allocating supply cost. LO 4-3 Identify the most appropriate cost driver. 164 Chapter 4 Assuming that total sales for the women’s, men’s, and children’s departments was $190,000, $110,000, and $60,000, respectively, ISI can allocate the supplies cost as ­follows: Step 1. Compute the allocation rate by dividing the total cost to be allocated ($900 supplies cost) by the cost driver ($360,000 total sales). Total cost to be allocated ÷ $900 supplies cost Step 2. ÷ Cost driver = Allocation rate $360,000 total sales = $0.0025 per sales dollar Multiply the allocation rate by the weight of the cost driver to determine the a­ llocation per cost object. Allocation Rate × Cost Object Total Sales = Allocation per Cost Object Women’s department $0.0025 × $190,000 = Men’s department 0.0025 × 110,000 = Children’s department 0.0025 × 60,000 = G Total $360,000 $475 275 150 $900 A T ISI believes the amount of sales is also the appropriate allocation base for advertising E cost. The sales generated in each department were likely influenced by the general advertisS advertising cost as follows: ing campaign. ISI can allocate Step 1. Compute the ,allocation rate by dividing the total cost to be allocated ($7,200 advertising cost) by the cost driver ($360,000 total sales). D Total cost to be allocated ÷ Ecost ÷ $7,200 advertising Step 2. Cost driver = Allocation rate $360,000 total sales = $0.02 per sales dollar A Multiply the allocation rate by the weight of the cost driver to determine the allocation per cost N object. D R A Allocation Rate × Total Sales = Women’s department $0.02 × Men’s department 0.02 × Children’s department 0.02 × 1 Total $190,000 = 110,000 = 60,000 = $360,000 Cost Object Allocation per Cost Object $3,800 2,200 1,200 $7,200 1 2 3 There is no strong cause-and-effect relationship between the store manager’s salary and the departments. ISITpays the store manager the same salary regardless of sales level, square footage of store space, number of labor hours, or any other identifiable variable. S driver exists, ISI must allocate the store manager’s salary Because no plausible cost a­ rbitrarily. Here the manager’s salary is simply divided equally among the departments as follows: Step 1. Compute the allocation rate by dividing the total cost to be allocated ($9,360 manager’s monthly salary) by the allocation base (number of departments). Total cost to be allocated ÷ Cost driver = Allocation rate $9,360 store manager’s salary ÷ 3 departments = $3,120 per department Cost Accumulation, Tracing, and Allocation Step 2. Multiply the allocation rate by the weight of the cost driver to determine the a­ llocation per cost object. Cost Object Allocation Rate × Number of Departments = Allocation per Cost Object Women’s department $3,120 × 1 = $3,120 Men’s department 3,120 × 1 = 3,120 Children’s department 3,120 × 1 = 3,120 Total 3 $9,360 As the allocation of the store manager’s salary demonstrates, many allocations are arbitrary or based on a weak relationship between the allocated cost and the ­allocation base (cost driver). Managers must use care when making decisions using ­allocated costs. G Using the indirect cost allocations just discussed, A Exhibit 4.3 shows the profit each department generated in January. ISI paid the three departmental managers bonuses based on T each department’s contribution to profitability. The store manager noticed an immediate E For example, the manager of the change in the behavior of the departmental managers. women’s department offered to give up 1,000 square S feet of floor space because she believed reducing the selection of available products would not reduce sales significantly. , Customers would simply buy different brands. Although sales would not decline dramatiBehavioral Implications cally, rent and utility cost allocations to the women’s department would decline, increasing the profitability of the department. D In contrast, the manager of the children’s department wanted the extra space. He beE lieved the children’s department was losing sales because it did not have enough floor space to display a competitive variety of merchandise. Customers came to the store to shop at the A women’s department, but they did not come specifically for children’s wear. With additional Nthat would draw customers to the store space, the children’s department could carry items specifically to buy children’s clothing. He believed D the extra space would increase sales enough to cover the additional rent and utility cost allocations. R A EXHIBIT 4.3 Profit Analysis by Department Women’s Sales Cost of goods sold Sales commissions Dept. managers’ salary Depreciation Store manager’s salary Rental fee for store Utilities Advertising Supplies Departmental profit $ 190,000 (120,000) (9,500) (5,000) (7,000) (3,120) (9,600) (1,200) (3,800) (475) $ 30,305 1 1 Department 2 Men’s 3 $110,000 T (58,000) (5,500) S (4,200) (5,000) (3,120) (5,600) (700) (2,200) (275) $ 25,405 Children’s Total $ 60,000 (38,000) (3,000) (2,800) (4,000) (3,120) (3,200) (400) (1,200) (150) $ 4,130 $ 360,000 (216,000) (18,000) (12,000) (16,000) (9,360) (18,400) (2,300) (7,200) (900) $ 59,840 165 166 Chapter 4 When we compare the cost that a hospi- Answers to the Curious Accountant tal charges for an aspirin to the price we pay for an aspirin, we are probably not considering the full cost that we incur to purchase aspirin. If someone were to ask you what you pay for an aspirin, you would probably take the price of a bottle, say $2, and divide it by the number of pills in the bottle, say 100. This would suggest their cost is $0.02 each. Now, consider what it costs to buy an aspirin when all costs are considered. First, there is your time to drive to the store; what do you get paid per hour? Then, there is the cost of operating your automobile. You get the idea; in reality, the cost of an aspirin, from a business perspective, is much more than just the cost of the pill itself. The exhibit below shows the income statement of Hospital Corporation of America (HCA), Inc. for three recent years. HCA claims to be “one of the leading health care services companies in the United States.” In 2014, it operated 279 facilities in 20 states and England. As you can see, while it generated over $40.1 billion in revenue, it also incurred a lot of expenses. Look at its first two expense categories. Although it incurred $6.3 billion in supplies expenses, it incurred G A deliver the aspirin to your bed than the aspirin itself costs. T In 2014, HCA earned $1.9 billion from its $40.1 billion in revenues. This is a return on sales percentage of 4.7 percent E ($1,875 ÷ $40,087). Therefore, on a $7 aspirin, HCA would earn 33 cents of profit, which is still not a bad profit for selling S one aspirin. As a comparison, in 2014, Walgreens, which also sells aspirin, had a return on sales of 2.7 percent. , over two and a half times this amount in compensation expense. In other words, it costs a lot more to have someone D INC. HCA, Consolidated E Income Statements For the Years Ended December 31, 2014, 2013, and 2012 A in millions) (dollars N D Revenues before the provision for doubtful accounts R Provision for doubtful accounts Revenues A Salaries and benefits Supplies Other operating expenses 1 Electronic health record incentive income 1 Equity in earnings of affiliates Depreciation and amortization 2 Interest expense 3 Losses (gains) on sales of facilities Losses on retirement of debt T Legal claim costs S Total expenses Income before income taxes Provision for income taxes Net income Net income attributable to noncontrolling interests Net income attributable to HCA, Inc. 2014 2013 2012 $40,087 3,169 36,918 16,641 6,262 6,755 (125) (43) 1,820 1,743 (29) 335 78 33,437 3,481 1,108 2,373 498 $ 1,875 $38,040 3,858 34,182 15,646 5,970 6,237 (216) (29) 1,753 1,848 10 17 $36,783 3,770 33,013 15,089 5,717 6,048 (336) (36) 1,679 1,798 (15) 31,236 2,946 950 1,996 440 $ 1,556 175 30,119 2,894 888 2,006 401 $ 1,605 Cost Accumulation, Tracing, and Allocation The store manager was pleased with the emphasis on profitability that resulted from tracing and assigning costs to specific departments. Cost Drivers for Variable Overhead Costs A causal relationship exists between variable overhead product costs (indirect materials, indirect labor, inspection costs, utilities, etc.) and the volume of production. For example, the cost of indirect materials such as glue, staples, screws, nails, and varnish will increase or decrease in proportion to the number of desks a furniture manufacturing company makes. Volume measures are good cost drivers for allocating variable overhead costs. Volume can be expressed by such measures as the number of units produced, the number of labor hours worked, or the amount of direct materials used in production. Given the variety of possible volume measures, how does management identify the most appropriate cost driver (allocation base) for assigning particular overhead costs? Consider the case of Filmier Furniture Company. Using Units as the Cost Driver During the most recent year, Filmier Furniture Company produced 4,000 chairs and 1,000 desks. It incurred $60,000 of indirect materials G cost during the period. How much of this cost should Filmier allocate to chairs versus desks? Using number of units as the cost A driver produces the following allocation: T E Total cost to be allocated ÷ Cost driver = Allocation rate S $60,000 indirect materials cost ÷ 5,000 units = $12 per unit , Step 1. Compute the allocation rate. Step 2. Multiply the allocation rate by the weight of the cost driver to determine the a­ llocation per cost object. D E of Allocation Number Product Rate × UnitsA Produced = Desks $12 × 1,000 = N Chairs 12 × 4,000 = Total D 5,000 = R A Allocated Cost $12,000 48,000 $60,000 Using Direct Labor Hours as the Cost Driver Using the number of units as the cost driver assigns an equal amount ($12) of indirect 1 materials cost to each piece of furniture. However, if Filmier uses more indirect materials to make a desk than to make a chair, assigning the1same amount of indirect materials cost to each is inaccurate. Assume Filmier incurs the following direct costs to make chairs 2 and desks: Desks Direct labor hours Direct materials cost 3,500 hrs. $1,000,000 3 T S Chairs Total 2,500 hrs. $500,000 6,000 hrs. $1,500,000 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 167 168 Chapter 4 hours they work, the more materials they use. Using this reasoning, Filmier could assign the indirect materials cost to the chairs and desks as follows: Step 1. Compute the allocation rate. Total cost to be allocated ÷ Cost driver = Allocation rate $60,000 indirect materials cost ÷ 6,000 hours = $10 per hour Step 2. Multiply the allocation rate by the weight of the cost driver. Product Allocation Rate × Number of Labor Hours = Desks $10.00 × 3,500 Chairs 10.00 × 2,500 Total 6,000 = = = Allocated Cost $35,000 25,000 $60,000 Basing the allocationGon labor hours rather than number of units assigns a significantly larger portion of the indirect A materials cost to desks ($35,000 versus $12,000). Is this allocation more accurate? Suppose the desks, but not the chairs, require elaborate, labor-intensive T of the labor is then not related to consuming indirect matericarvings. A significant portion als (glue, staples, screws,Enails, and varnish). It would therefore be inappropriate to allocate the indirect materials cost based on direct labor hours. S Using Direct Material ,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)DFilmier uses, the more glue, nails, and so forth (indirect materials) it uses. It is reasonable E to presume direct materials usage drives indirect materials usage. Using direct materials dollars as the cost driver for indirect materials produces the ­following allocation: A Step 1. Compute the N allocation rate. Total cost toDbe allocated ÷ Rindirect $60,000 materials A cost Step 2. ÷ Cost driver = Allocation rate $1,500,000 direct $00.04 per direct = material dollars material dollar Multiply the allocation rate by the weight of the cost driver. 1 1 Allocation Number of Direct Product × Material Dollars = 2Rate Desks $0.04 × $1,000,000 = 3 Chairs 0.04 × 500,000 = T Total $1,500,000 = S Allocated Cost $40,000 20,000 $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, direct material dollars appears to have the most convincing relationship to indirect materials usage. If the cost Filmier was allocating were fringe benefits, Cost Accumulation, Tracing, and Allocation h­ owever, direct labor hours would be a more appropriate cost driver. If the cost Filmier was allocating were machine maintenance cost, a different volume-based cost driver, machine hours, would be an appropriate base. The most accurate allocations of indirect costs may actually require using multiple cost drivers. CHECK YOURSELF 4.2 Boston Boat Company builds custom sailboats for customers. During the current accounting period, the company built five different-sized boats that ranged in cost from $35,000 to $185,000. The company’s manufacturing overhead cost for the period was $118,000. Would you recommend using the number of units (boats) or direct labor hours as the base for allocating the overhead cost to the five boats? Why? Answer Using the number of units as the allocation base would assign the same amount of overhead cost to each boat. Since larger boats require more overhead cost (supplies, utilities, equipment, etc.) than smaller boats, there is no logical link between the number of boats and the amount of overhead cost required to build a particular boat. In contrast, there is a logical link between direct labor hours G used and overhead cost incurred. The more labor used, the more supplies, utilities, equipment, and so on used. Since larger boats require more direct labor thanAsmaller boats, using direct labor hours as the allocation base would allocate more overhead cost to larger boats and less overhead cost to smaller T boats, producing a logical overhead allocation. Therefore, Boston should use direct labor hours as the E allocation base. S , Cost Drivers for Fixed Overhead Costs D Fixed costs present a different cost allocation problem. By E definition, the volume of production does not drive fixed A its manucosts. Suppose Lednicky Bottling Company rents facturing facility for $28,000 per year. The rental N cost is fixed regardless of how much product Lednicky bottles. However, Lednicky may still use a volume-basedDcost driver as the allocation base. The object of allocating fixed R costs to products is to distribute a rational share of the overhead cost to each product. Selecting an allocation base thatAspreads total overhead cost equally over total production often produces a rational distribution. For example, assume Lednicky produced 2,000,000 bottles of apple juice during1the current accounting period. If it sold 1,800,000 bottles 1 of the juice during this period, how much of the $28,000 rental cost 2 to cost of should Lednicky allocate to ending inventory and goods sold? A rational allocation follows: 3 Step 1. © John A. Rizzo/Getty Images Compute the allocation rate. T S driver) = Total cost to be allocated ÷ Allocation base (cost $28,000 rental cost ÷ 2,000,000 units Allocation rate = $0.014 per bottle of juice Because the base (number of units) used to allocate the cost does not drive the cost, it is sometimes called an allocation base instead of a cost driver. However, many managers use the term cost driver in conjunction with fixed cost even though that usage is ­technically inaccurate. The terms allocation base and cost driver are frequently used ­interchangeably. 169 170 Chapter 4 Step 2. Multiply the allocation rate by the weight of the cost driver. Financial Statement Item Inventory Cost of goods sold Allocation Rate × $0.014 0.014 × × Number of Bottles = 200,000 1,800,000 = = Allocated Cost $ 2,800 25,200 Using number of units as the allocation base assigns equal amounts of the rental cost to each unit of product. Equal allocation is appropriate so long as the units are homogeneous. If the units are not identical, however, Lednicky may need to choose a different allocation base to rationally distribute the rental cost. For example, if some of the bottles are significantly larger than others, Lednicky may find using some physical measure, like liters of ­direct material used, to be a more appropriate allocation base. Whether an indirect cost is fixed or variable, selecting the most appropriate allocation base requires sound reasoning and judgment. G Allocating Fixed Costs When the Volume of Production Varies A products may be made before or after the costs associated with Under certain circumstances making them have been T incurred. Suppose, for example, premiums for an annual insurance policy are paid in March. The insurance cost benefits the products made in the months beE as those produced in March. Allocation can be used to spread fore and after March as well the insurance cost over products made during the entire accounting period rather than chargS ing the total cost only to products made in March. Monthly fluctuations, in production volume complicate fixed cost allocations. To illustrate, assume Grave Manufacturing pays its production supervisor a monthly salary of $3,000. Furthermore, assume Grave makes 800 units of product in January and 1,875 in D cost should Grave assign to the products made in January and February. How much salary February, respectively? The E allocation seems simple. Just divide the $3,000 monthly salary cost by the number of units of product made each month as follows: A January N $3,000 ÷ 800 units = $3.75 cost per unit February D $3,000 ÷ 1,875 units = $1.60 cost per unit R based a cost-plus pricing decision on these results, it would If Grave Manufacturing price products made in January significantly higher than products made in February. It is A likely such price fluctuations would puzzle and drive away customers. Grave needs an allocation base that will spread the annual salary cost evenly over annual production. A timing problem exists, however,1because Grave must allocate the salary cost before the end of the year. In order to price its products, Grave needs to know the allocated amount before the actual cost information 1 is available. Grave can manage the timing problem by using estimated rather than actual 2 costs. Grave Manufacturing can estimate the annual cost of the supervisor’s salary (indirect labor) as $36,000 ($3,0003× 12 months). The actual cost of indirect labor may differ because the supervisor might receive T a pay raise or be replaced with a person who earns less. Based on current information, however, $36,000 is a reasonable estimate of the annual indirect laS bor cost. Grave must also estimate total annual production volume. Suppose Grave produced 18,000 units last year and expects no significant change in the current year. It can allocate indirect labor cost for January and February as follows: Step 1. Compute the allocation rate. Total cost to be allocated ÷ Allocation base = Allocation rate (cost driver) $36,000 ÷ 18,000 units = $20.00 per unit Cost Accumulation, Tracing, and Allocation 171 Multiply the rate by the weight of the base (number of units per month) to determine how much of the salary cost to allocate to each month’s production. Step 2. Allocation Rate × Month January February $2.00 2.00 × × Number of Units Produced = 800 1,875 Allocation per Month = = $1,600 3,750 Grave Manufacturing will add these indirect cost allocations to other product costs to determine the total estimated product cost to use in cost-plus pricing or other managerial decisions. Because the overhead allocation rate is determined before actual cost and volume data are available, it is called the predetermined overhead rate. Companies use predetermined overhead rates for product costing estimates and pricing decisions during a year, but they must use actual costs in published year-end financial statements. If necessary, companies adjust their accounting records at year-end when they have used estiG for making such adjustments are mated data on an interim basis. The procedures discussed in a later chapter. A T ALLOCATING JOINT COSTS E S Joint costs are common costs incurred in the process of making two or more joint ­products. The cost of raw milk is a joint cost ,of producing the joint products cream, whole milk, 2 percent milk, and skim milk. Joint costs include not only materials costs but also the labor and overhead costs of converting the materials into separate products. D become separate and identifiable The point in the production process at which products is the split-off point. For financial reporting of inventory and cost of goods sold, compaE nies must allocate the joint costs to the separate joint products. Some joint products reA quire additional processing after the split-off point. Any additional materials, labor, or overhead costs incurred after the split-off point N are assigned to the specific products to which they relate. D To illustrate, assume Westar Chemical Company produces from common raw materiR AL. Compound AL requires further als the joint products Compound AK and Compound processing before Westar can sell it. The diagramAin Exhibit 4.4 illustrates the joint product costs. The joint costs of producing a batch of the two compounds are $48,000, representing $27,000 of materials cost and $21,000 of processing 1 cost. A batch results in 3,000 gallons of EXHIBIT 4.4 Allocation of Joint Cost Joint materials $27,000 Joint processing $21,000 Total joint costs $48,000 Compound AK $36,000 Split-off point Compound AL $12,000 1 2 3 T S Sales $50,000 COGS (36,000) Gross margin $14,000 Joint products Additional processing $8,000 Sales $13,000 COGS (20,000) Gross margin $(7,000) LO 4-4 Allocate joint costs to joint products. 172 Chapter 4 Compound AK and 1,000 gallons of Compound AL. Westar allocates joint costs to the products based on the number of gallons produced, as follows: Compute the allocation rate. Step 1. Total cost to be allocated ÷ Allocation base = Allocation rate $48,000 joint costs ÷ 4,000 gallons = $12 per gallon Multiply the allocation rate by the weight of the base. Step 2. Joint Product Allocation Number of Allocated Rate × Gallons Produced = Cost Compound AK Compound AL × × $12 12 = = 3,000 1,000 $36,000 12,000 Westar sells 3,000 gallons of Compound AK for $50,000 and 1,000 gallons of Compound AL for $13,000. Exhibit 4.4 shows the gross margins for each product using the joint cost allocations computed above. G as the Allocation Base Relative Sales Value Because Compound ALAshows a $7,000 loss, a manager might mistakenly conclude that Westar should stop making T and selling this product. If Westar stops making Compound AL, the total joint cost ($48,000) would be assigned to Compound AK and total gross margin would decline as shown E below. S With Without , Compound AL Compound AL Sales Cost of goods sold D Gross margin $ 63,000 ($50,000 + $13,000) (56,000) ($36,000 + $20,000) $ 7,000 $ 50,000 (48,000) $ 2,000 E A To avoid the appearance that a product such as Compound AL is producing losses, many companies allocate joint costN to products based on the relative sales value of each product at the split-off point. Westar Chemical would allocate all of the joint costs to Compound AK because D Compound AL has no market value at the split-off point. The resulting gross margins follow. R Compound AK Compound AL A Sales Cost of goods sold 1 Gross margin $ 50,000 (48,000) $ 2,000 $13,000 (8,000) $ 5,000 1 2 joint products is $7,000 whether it allocates the joint costs using Westar’s total profit on the gallons or relative market3value. However, using market value as the allocation base p­ roduces a positive gross margin for both products, reducing the likelihood that a manager will T ­mistakenly eliminate a product that is contributing to profitability. S CHECK YOURSELF 4.3 What are some logical split-off points for a meat processing company engaged in butchering beef? The first logical split-off point occurs when processing separates the hide (used to produce leather) from the carcass. Other split-off points occur as further processing produces different cuts of meat (T-bone and New York strip steaks, various roasts, chops, ground chuck, etc.). Answer Cost Accumulation, Tracing, and Allocation THE HUMAN FACTOR: A COMPREHENSIVE EXAMPLE Cost allocations significantly affect individuals. They may influence managers’ performance evaluations and compensation. They may dictate the amount of resources various departments, divisions, and other organizational subunits 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 Sharon Southport, dean of the School of Business at a major state university, is in dire need of a budgeting plan. Because of cuts in state funding, the money available to the School of Business for copying costs next year will be reduced substantially. Dean Southport supervises four departments: management, marketing, finance, and accounting. The dean knows the individual department chairpersons will be unhappy and frustrated with the deep cuts they face. G Using Cost Drivers to Make AllocationsA T Southport decided to meet with the To address the allocation of copying resources, Dean department chairs. She explained that the total budgeted E for copying costs will be $36,000. Based on past usage, department allocations would be as follows: $12,000 for management, S for marketing. $10,000 for accounting, $8,000 for finance, and $6,000 Dr. Bill Thompson, the management department , chair, immediately protested that his department could not operate on a $12,000 budget for copy costs. Management has more faculty members than any other department. Dr. Thompson argued that copy costs are directly related to the number of faculty members, soDcopy funds should be allocated based on the number of faculty members. Dr. Thompson suggested that number of faculty members E rather than past usage should be used as the allocation base. A members (29 in management, 16 in Since the School of Business has 72 faculty ­accounting, 12 in finance, and 15 in marketing), the Nallocation should be as follows: Step 1. Compute the allocation rate. D Total cost to be allocated ÷ Cost driver R= $36,000 Step 2. ÷ 72 Allocation rate A = $500 per faculty member Multiply the rate by the weight of the driver (the number of faculty per department) to determine the allocation per object (department). 1 Allocation Number of 1 Allocation per Department Rate × Faculty = 2 Department Management $500 × 29 = $14,500 3 Accounting 500 × 16 = 8,000 Finance 500 × 12 =T 6,000 Marketing 500 × 15 = 7,500 S Total $36,000 Allocation Based on Past Usage $12,000 10,000 8,000 6,000 $36,000 Seeing these figures, Dr. Bob Smethers, chair of the accounting department, questioned the accuracy of using the number of faculty members as the cost driver. Dr. Smethers suggested the number of students rather than the number of faculty members drives the cost of copying. He argued that most copying results from duplicating syllabi, exams, and handouts. The accounting department teaches mass sections of introductory accounting that have ­extremely high student/teacher ratios. Because his department teaches more students, it LO 4-5 Recognize the effects of cost allocation on employee motivation. 173 174 Chapter 4 spends more on copying costs even though it has fewer faculty members. Dr. Smethers recomputed the copy cost allocation as follows: Step 1. Compute the allocation rate based on number of students. University records indicate that the School of Business taught 1,200 students during the most recent academic year. The allocation rate (copy cost per student) follows. Total cost to be allocated ÷ Cost driver = Allocation rate $36,000 Step 2. ÷ 1,200 = $30 per student Multiply the rate by the weight of the driver (number of students taught by each department) to determine the allocation per object (department). Department Allocation Rate × Number of Students = Allocation per Department Management $30 × 330 = $ 9,900 Accounting 30 × 360 = 10,800 Finance 30 × 290 = 8,700 Marketing 30 × 220 = 6,600 Total $36,000 G Allocation Based on Past Usage $12,000 10,000 8,000 6,000 $36,000 A Choosing the Best T Cost Driver Dr. Thompson objected E vigorously to using the number of students as the cost driver. He continued to argue that the size of the faculty is a more appropriate allocation base. The S chair of the finance department sided with Dr. Smethers, the chair of the marketing department kept quiet, and the ,dean had to settle the dispute. Dean Southport recognized that the views of the chairpersons were influenced by selfinterest. The allocation base affects the amount of resources available to each department. D Furthermore, the dean recognized that the size of the faculty does drive some of the copying costs. For example, the cost of copying manuscripts that faculty submit for publication reE lates to faculty size. The more articles faculty submit, the higher the copying cost. NevertheA number of students has the most significant impact on copying less, the dean decided the costs. She also wanted toN encourage faculty members to minimize the impact of funding cuts on student services. Dean Southport therefore decided to allocate copying costs based on the D by each department. Dr. Thompson stormed angrily out of the number of students taught meeting. The dean developed R a budget by assigning the available funds to each department using the number of students as the allocation base. A Controlling Emotions Dr. Thompson’s behavior1may relieve his frustration but it doesn’t indicate clear thinking. Dean Southport recognized that Dr. Thompson’s contention that copy costs were related to faculty 1 size had some merit. Had Dr. Thompson offered a compromise rather than an emotional out2 his department’s share of the funds. Perhaps a portion of the burst, he might have increased ­allocation could have been 3 based on the number of faculty members with the balance allocated based on the number of students. Had Dr. Thompson controlled his anger, the others might have T agreed to compromise. Technical expertise in computing numbers is of little use without the interpersonal skills to persuade others. Accountants may provide numerical measurements, but S they should never forget the impact of their reports on the people in the organization. > that impairs decision making. The next chapter explains how increased use of automation in production has caused distortion in allocations determined using traditional approaches. The chapter introduces the allocation of indirect costs1using more recently developed activitybased costing and explains how activity-based management can improve efficiency and pro1 ductivity. Finally, the chapter introduces total quality management, a strategy that seeks to 2 minimize the costs of conforming to a designated standard of quality. APPENDIX 3 T S Allocating Service Center Costs Most organizations establish departments responsible for accomplishing specific tasks. ­Departments that are assigned tasks leading to the accomplishment of the primary objectives of the organization are called operating departments. Those that provide support to operating departments are called service departments. For example, the department of accounting at a university is classified as an operating department because its faculty perform the university’s primary functions of teaching, research, and service. In contrast, the maintenance ­department is classified as a service department because its employees provide janitorial LO 4-6 Allocate service department costs to operating departments. 176 Chapter 4 s­ ervices that support primary university functions. Professors are more likely to be motivated to perform university functions when facilities are clean, but the university’s primary purpose is not to clean buildings. Similarly, the lending department in a bank is an operating department and the personnel department is a service department. The bank is in the business of making loans. Hiring employees is a secondary function that assists the lending activity. The costs to produce a product (or a service) include both operating and service department costs. Therefore, service department costs must somehow be allocated to the products produced (or services provided). Service department costs are frequently distributed to products through a two-stage allocation process. First-stage allocations involve the distribution of costs from service center cost pools to operating department cost pools. In the second stage, costs in the operating cost pools are allocated to products. Three different approaches can be used to allocate costs in the first stage of the two-stage costing process: the direct method, the step method, and the reciprocal method. Direct Method The direct method is the simplest allocation approach. It allocates service department costs directly to operating department cost pools. To illustrate, assume that Candler & Associates is a law firm that desires Gto determine the cost of handling each case. The firm has two ­operating departments, one that represents clients in civil suits and the other that defends A The two operating departments are supported by two service clients in criminal cases. ­departments, personnel and T secretarial support. Candler uses a two-stage allocation system to allocate the service centers’ costs to the firm’s legal cases. In the first stage, the costs to E operate each service department are accumulated in separate cost pools. For example, the costs to operate the personnel department are $80,000 in salary, $18,000 in office rental, S $12,000 in depreciation, $3,000 in supplies, and $4,000 in miscellaneous costs. These costs , are added together in a single services department cost pool amounting to $117,000. Similarly, the costs incurred by the secretarial department are accumulated in a cost pool. We assume that this cost pool contains $156,800 of accumulated costs. The amounts in these D to the operating departments’ cost pools. The appropriate allocost pools are then allocated cations are described in the E following paragraphs. Assume that Candler’s accountant decides that the number of attorneys working in the A two operating departments constitutes a rational cost driver for the allocation of the personnel department cost poolNand that the number of request forms submitted to the secretarial department constitutes a rational cost driver for the allocation of costs accumulated in the D secretarial department cost pool. The total number of attorneys working in the two operating departments is 18: 11 inR the civil department and 7 in the criminal department. The secretarial department received A 980 work request forms with 380 from the civil department and 600 from the criminal department. Using these cost drivers as the allocation bases, the accountant made the following first-stage allocations. 1 1 Allocation rate for personnel $117,000 2 cost pool ÷ 18 = $6,500 per attorney department 3 for secretarial $156,800 Allocation rate ÷ = $160 per request form department T cost pool 980 The accountant thenSmultiplied these rates by the weight of the base to determine the Determination of Allocation Rates amount of each service cost pool to allocate to each operating department cost pool. The a­ ppropriate computations are shown in Exhibit 4.5. As indicated, the allocated service department costs are pooled with other operating ­department overhead costs to form the operating department cost pools. In the second stage of the costing process, the costs in the operating department cost pools are allocated to the firm’s products (cases). To illustrate second-stage allocations, assume that Candler allocates the operating department overhead cost pools on the basis of billable hours. Furthermore, ­assume that the civil department expects to bill 30,580 hours to its clients and the criminal Cost Accumulation, Tracing, and Allocation 177 EXHIBIT 4.5 First-Stage Allocations for Candler & Associates—Direct Method Allocated Service Department Allocation Weight of Civil Criminal Overhead Rate × Base = Department Department $6,500 × 11 attorneys = $ 71,500 6,500 × 7 attorneys = $ 45,500 Total cost of personnel department Secretarial 160 × 380 requests = 60,800 160 × 600 requests = 96,000 Total cost of secretarial department Total of cost pools after allocation 132,300 141,500 Other operating department overhead costs 785,100 464,788 Total of operating department overhead cost pools $917,400 $606,288 Total Service Department Cost Pool Personnel G department expects to bill 25,262 hours. Based on this information, the following predetermined overhead rates are used to allocate operatingA department cost pools to particular cases. T Predetermined overhead rate $917,400 = E = $30 per billable hour for the civil department 30,580 S Predetermined overhead rate $606,288 = for the criminal department , = $24 per billable hour 25,262 These rates are used to calculate the amount of operating department cost pools to include in the determination of the cost to litigateDspecific cases. For example, a case in the civil department that required 300 billable hours E of legal service is allocated $9,000 (300 hours × $30 predetermined overhead rate) of overhead cost. Assuming that the direct A cost of this particular case is $34,000 costs to litigate the case amounted to $25,000, the total ($25,000 direct cost + $9,000 allocated overhead). NThis accumulated cost figure could be used as a guide to determine the charge to the client or the profitability of the case. D R Step Method A fails to consider the fact that service The direct method of allocating service center costs departments render assistance to other service departments. A service that is performed by one service department for the benefit of another service department is called an interdepartmental service. To illustrate this, we return to1the case of Candler & Associates. Suppose that Candler’s personnel department works1 with the employees in the secretarial department as well as the attorneys in the civil and criminal operating departments. Under 2 these circumstances, Candler needs a cost approach that recognizes the interdepartmental 3 step method. The primary difference service activity. One such approach is known as the between the direct method and the step method is depicted graphically in Exhibit 4.6. Focus T your attention on the first stage of the allocation process. Notice that the step method includes one additional allocation, specifically from S the personnel department cost pool to the secretarial department cost pool. The direct method ignores this interdepartmental service cost allocation. Indeed, the direct method derives its name from the fact that it allocates costs only from service cost pools to operating cost pools. The fact that the direct method ignores the effect of interdepartmental services may cause distortions in the measurement of cost objects. The primary purpose of the step method is to avoid such distortions, thereby improving the accuracy of product costing. To illustrate this point, consider Candler & Associates. First, note that the interdepartmental portion of the personnel department cost is, in fact, a cost of providing secretarial services. $117,000 156,800 $273,800 178 Chapter 4 EXHIBIT 4.6 Comparison of Direct and Step Allocation Methods Direct method Personnel service department First-stage allocations Civil operating department Step method Secretarial service department Personnel service department Criminal operating department Civil operating department Second-stage allocations Cases Secretarial service department First-stage allocations Criminal operating department Second-stage allocations Cases Cases Cases G A In other words, the personnel service costs could be reduced if the personnel department did not provide service to theTsecretarial staff. Accordingly, the cost of providing personnel support to the secretarial staff E should be included in the secretarial cost pool. Under the direct method, however, the interdepartmental service cost is allocated between the civil and crimS inal operating departments. This is not a problem in and of itself because the cost of secre, tarial service is also allocated between the civil and criminal operating departments. Unfortunately, the base used to allocate personnel costs to the operating departments (i.e., number of attorneys) distributes more cost to the civil department than to the criminal D ­department. This is unfortunate because the criminal department uses more secretarial ­service than the civil department does. In other words, more secretarial cost (i.e., interdeE partmental personnel cost) is being allocated to the civil department although the criminal A department uses more secretarial services. This means that ultimately the cost to litigate civil cases will be overstated N and the cost to litigate criminal cases will be understated. The step method corrects this distortion by distributing the interdepartmental personnel D department cost to the secretarial department cost pool before it is allocated to the operating departments. Because theRsecretarial cost pool is allocated on the basis of requests for secretarial service, more of the interdepartmental cost will be allocated to the criminal operating department. To validate A this result, assume that the personnel department cost pool is allocated to the secretarial department cost pool and the two operating department cost pools on the basis of the number of employees in each department. In addition to the 18 attorneys in 1 the firm, assume that two employees work in the secretarial department. Accordingly, the allocation rate for the personnel cost pool is calculated as follows: 1 2 for personnel $117,000 Allocation rate = $5,850 per employee = department 20 3 cost pool Based on this rate, T the first step in the allocation process distributes the personnel ­department cost pool as indicated here: S Personnel Cost Pool Allocated to Allocation Rate Weight of Base Secretarial $5,850 ×   2 employees = Civil 5,850 × 11 employees = Criminal 5,850 × 7 employees = Total 20 employees Allocated Cost $ 11,700 64,350 40,950 $117,000 Cost Accumulation, Tracing, and Allocation 179 EXHIBIT 4.7 First-Stage Allocations for Candler & Associates—Step Method Personnel Cost Pool Secretarial Cost Pool Cost to be allocated $ 117,000 $ 156,800 Step 1 allocation (117,000) = 11,700 + Step 2 allocation (168,500) = Total in cost pool after allocation $ 0 $ 0 Other operating department overhead costs Total of operating department overhead cost pool Civil Department $ 64,350 + 65,337 + 129,687 785,100 $914,787 The result of the distribution of personnel department costs is shown as the step 1 allocation in Exhibit 4.7. The $11,700 interdepartmental personnel department cost allocated to the secretarial department cost pool is added to the $156,800 existing balance in that cost pool (see Exhibit 4.7). The result is the accumulation of secretarial cost of $168,500. The second step in the costing process allocates this G cost pool to the operating departments. ­Recall that the secretarial cost pool is allocated A on the basis of number of work request forms submitted. Furthermore, recall that 980 request forms were submitted to the secretarT from the criminal department). Accordial department (380 from the civil department and 600 ingly, the allocation rate for the secretarial department E cost pool is computed as follows: $168,500 Allocation rate for secretarial S = $171.93878 per request form = department cost pool 980 , Based on this rate, the second step in the allocation process distributes the secretarial cost pool as indicated here: D EWeight of Secretarial Cost Allocation Allocated Pool Allocated to Rate Base Cost A Civil $171.93878 × requests = $ 65,337 N380 Criminal 171.93878 × 600 requests =  103,163 D980 requests Total $168,500 R A 2 allocation in Exhibit 4.7. Notice that The result of this allocation is shown as the step the final cost pools for the operating departments reflect the expected shift in the cost distribution between the two departments. Specifically, the cost pool in the criminal department is higher and the cost pool in the civil department1is lower than the comparable cost pool amounts computed under the direct method (see 1 Exhibit 4.5 for the appropriate comparison). This distribution of cost is consistent with the fact that more of the interdepartmental 2 service cost should be assigned to the criminal department because it uses more secretarial 3 the step method of allocation more services than does the civil department. Accordingly, accurately reflects the manner in which the two operating departments consume resources. T The preceding illustration considered a simple two-stage allocation process with only two service departments and two operating departments.SIn large organizations, the costing process may be significantly more complex. Interdepartmental cost allocations may involve several service departments. For example, a personnel department may provide service to a secretarial department that provides service to an engineering department that provides service to the accounting department that provides service to several operating departments. In addition, general overhead costs may be allocated to both service and operating departments before costs are allocated from service to operating departments. For example, general utility costs may be pooled together and allocated to service and operating departments on the basis of square ­footage of floor space. These allocated utility costs are then redistributed to other service Criminal Department $ 40,950 103,163 144,113 464,788 $608,901 180 Chapter 4 d­ epartments and to operating departments in a sequence of step-down allocations. The stepdown process usually begins with the cost pool that represents resources used by the largest number of departments. This constitutes the first step in the costing process. The second step proceeds with allocations from the cost pool that represents resources used by the second largest number of departments and so on, until all overhead costs have been allocated to the operating departments. Accordingly, the first stage of a two-stage costing process may include many allocations (steps) before all costs have been distributed to the operating departments. Regardless of how many allocations are included in the first stage, the second stage begins when costs are allocated from the operating departments to the organization’s products. Reciprocal Method Note that the step method is limited to one-way interdepartmental relationships. In practice, many departments have two-way working relationships. For example, the personnel department may provide services to the secretarial department and receive services from it. Twoway associations in which departments provide and receive services from one another are called reciprocal relationships. Allocations that recognize reciprocal relationships require complex mathematical manipulation involving the use of simultaneous linear equations. The resultant cost distributions are difficult to interpret. Furthermore, the results attained with the reciprocal method are G not significantly different from those attained through the step method. As a result, the reciprocal method is rarely used in practice. A T E Video lectures and accompanying S self-assessment quizzes are available in Connect for all learning objectives. , SELF-STUDY REVIEW PROBLEM D pressured Body Perfect Gym to control costs. The owner of the gym, New budget constraints have Mr. Ripple, has notified division managers that their job performance evaluations will be highly influE enced by their ability to minimize costs. The gym has three divisions: weight lifting, aerobics, and A spinning. The owner has formulated a report showing how much it cost to operate each of the three divisions last year. In preparing the report, Mr. Ripple identified several indirect costs that must be N allocated among the divisions. These indirect costs are $4,200 of laundry expense, $48,000 of supplies, $350,000 of office rent, D $50,000 of janitorial services, and $120,000 for administrative salaries. To provide a reasonably accurate cost allocation, Mr. Ripple has identified several potential cost drivR ers. These drivers and their association with each division follow: A Cost Driver Weight Lifting 1 26 10 1 12,000 2 2 3 Required T a. Identify the appropriateScost objects. Number of participants Number of instructors Square feet of gym space Number of staff Aerobics Spinning Total 16 8 6,000 2 14 6 7,000 1 56 24 25,000 5 b. Identify the most appropriate cost driver for each indirect cost, and compute the allocation rate for assigning each indirect cost to the cost objects. c. Determine the amount of supplies expense that should be allocated to each of the three divisions. d. The spinning manager wants to use the number of staff rather than the number of instructors as the allocation base for the supplies expense. Explain why the spinning manager would take this position. e. Identify two cost drivers other than your choice for Requirement b that could be used to allocate the cost of the administrative salaries to the three divisions. Cost Accumulation, Tracing, and Allocation Solution to Requirement a The objective is to determine the cost of operating each division. Therefore, the cost objects are the three divisions (weight lifting, aerobics, and spinning). Solution to Requirement b The costs, appropriate cost drivers, and allocation rates for assigning the costs to the departments ­follow: Cost Base Computation Laundry expense Supplies Office rent Janitorial service Administrative salaries Number of participants Number of instructors Square feet Square feet Number of divisions $ 4,200 ÷ 56 48,000 ÷ 24 350,000 ÷ 25,000 50,000 ÷ 25,000 120,000 ÷ 3 Allocation Rate $75 per participant $2,000 per instructor $14 per square foot $2 per square foot $40,000 per division There are other logical cost drivers. For example, the cost of supplies could be allocated based on the number of staff. It is also logical to use a combination of cost drivers. For example, the allocation for G the cost of supplies could be based on the combined number of instructors and staff. For this problem, we assumed that Mr. Ripple chose the number of instructors A as the base for allocating supplies expense. Solution to Requirement c Department Cost to Be Allocated T E Allocation S× Rate Weight = , Amount Allocated Weight lifting Supplies $2,000 × 10 = $20,000 Aerobics Supplies 2,000 × 8 = 16,000 Spinning Supplies 2,000 × 6 = 12,000 D Total $48,000 E A Solution to Requirement d N If the number of staff were used as the allocation base, the allocation rate for supplies would be D as follows: $48,000 ÷ 5 staff = $9,600 R per staff member A among the three divisions as follows: Using this rate, the total cost of supplies would be allocated Department Cost to Be Allocated Allocation 1 Rate × 1 Weight of Base = Amount Allocated Weight lifting Supplies $9,600 × 2 = $19,200 2× Aerobics Supplies 9,600 2 = 19,200 Spinning Supplies 9,600 1 = 9,600 3× Total $48,000 T S By using the number of staff as the allocation base instead of the number of instructors, the amount of overhead cost allocated to the spinning division falls from $12,000 to $9,600. Since managers are evaluated based on minimizing costs, it is clearly in the spinning manager’s self-interest to use the number of staff as the allocation base. Solution to Requirement e Among other possibilities, bases for allocating the administrative salaries include the number of participants, the number of lessons, or the number of instructors. 181 182 Chapter 4 KEY TERMS allocation 160 allocation base 161 allocation rate 161 common costs 160 controllable costs 160 cost accumulation 158 cost allocation 159 cost driver 158 cost objects 156 cost pool 162 cost tracing 159 direct cost 159 direct method 176 indirect cost 159 interdepartmental service 177 joint costs 171 joint products 171 operating departments 175 overhead costs 159 predetermined overhead rate 171 reciprocal method 180 reciprocal relationships 180 service departments 175 split-off point 171 step method 177 costs are not affected by the level of production ­activity and have not yet been incurred. The managers can reasonably estimate the overhead costs for the year based on the fixed indirect costs incurred in past periods. Assume the managers decide to allocate an equal amount of these estimated costs to the products produced each month. ­Explain why this practice may not provide a reasonable estimate of product costs in January. 13. Respond to the following statement: “The allocation base chosen is unimportant. What is important in product costing is that overhead costs be assigned to production in a specific period by an allocation process.” 14. Larry Kwang insists that the costs of his school’s fund-raising project should be determined ­after the project is complete. He ­argues that only after the project is complete can its costs be ­determined accurately and that it is a waste of time to try to estimate ­future costs. Georgia ­Sundum counters that waiting until the project is complete will not provide timely information for planning expenditures. How would you arbitrate this discussion? Explain the trade-offs between ­accuracy and timeliness. 15. What are the three methods used for allocating service center costs? How do the methods differ? ­(Appendix) QUESTIONS 1. What is a cost object? Identify four different cost objects in which an ­accountant would be interested. 2. Why is cost accumulation imprecise? 3. If the cost object is a manufactured product, what are the three major cost categories to accumulate? 4. What is a direct cost? What criteria are used to determine whether a cost is a ­direct cost? 5. Why are the terms direct cost and indirect cost independent of the terms fixed cost and variable cost? Give an example to ­illustrate. 6. Give an example of why the statement “All direct costs are avoidable” is ­incorrect. 7. What are the important ­factors in determining the 8. 9. 10. 11. 12. appropriate cost driver to use in allocating a cost? How is an allocation rate determined? How is an ­allocation made? In a manufacturing environment, which costs are G direct and which are indirect in product costing?A Why are some manufacturing costs not directly T ­traceable to products? E What is the objective of S ­allocating indirect manu, to facturing overhead costs the product? On January 31, the managers of Integra, Inc. seekD to determine the cost of proE ducing their product during A January for product pricing and control purposes. The N company can easily determine the costs of directD materials and direct labor R used in January production, but many fixed indirectA 1 1 Multiple-choice questions are available in Connect. 2 3 T All applicable Exercises in Series A are available in Connect. S MULTIPLE-CHOICE QUESTIONS EXERCISES—SERIES A LO 4-1 Exercise 4-1A Direct versus indirect costs Ludmilla Construction Company is composed of two divisions: (1) Home Construction and (2) Commercial Construction. The Home Construction Division is in the process of building 12 houses and the Commercial Construction Division is working on three projects. Cost items of the company follow: Wages of workers assigned to a specific construction project Supplies used by the Commercial Construction Division Labor on a particular house Cost Accumulation, Tracing, and Allocation Salary of the supervisor of commercial construction projects Supplies, such as glue and nails, used by the Home Construction Division Cost of building permits Materials used in commercial construction projects Depreciation on home building equipment (small tools such as hammers or saws) Company president’s salary Depreciation on crane used in commercial construction Depreciation on home office building Salary of corporate office manager Required a. Identify each cost as being a direct or indirect cost assuming the cost objects are the individual products (houses or projects). b. Identify each cost as being a direct or indirect cost, assuming the cost objects are the two divisions. c. Identify each cost as being a direct or indirect cost assuming the cost object is Ludmilla Construction Company as a whole. Exercise 4-2A Allocating costs between divisions G LO 4-2 T E Determine the amount of the fringe benefits cost to be allocated to Division A and to Division B. S Exercise 4-3A Allocating overhead cost to accomplish smoothing , LO 4-2 Beasley Services Company (BSC) has 50 employees, 28 of whom are assigned to Division A and A 22 to Division B. BSC incurred $450,000 of fringe benefits cost during 2018. Required Rasmussen Corporation expects to incur indirect overhead costs of $80,000 per month and direct manufacturing costs of $12 per unit. The expected production activity for the first four months of 2017 D is as follows: E January A February March April N Estimated production in units 6,000 7,000 3,000 4,000 D R Required A a. Calculate a predetermined overhead rate based on the number of units of product expected to be made during the first four months of the year. b. Allocate overhead costs to each month using the overhead 1 rate computed in Requirement a. c. Calculate the total cost per unit for each month using the overhead allocated in Requirement b. 1 Exercise 4-4A Pooling overhead cost 2 Ware Manufacturing Company produced 2,000 units of3inventory in January 2018. It expects to produce an additional 14,000 units during the remaining 11 months of the year. In other words, total T production for 2018 is estimated to be 16,000 units. Direct materials and direct labor costs are $64 and $52 per unit, respectively. Ware expects to incur the following manufacturing overhead costs during S the 2018 accounting period: Production supplies Supervisor salary Depreciation on equipment Utilities Rental fee on manufacturing facilities $ 20,000 160,000 75,000 20,000 45,000 LO 4-2 183 184 Chapter 4 Required a. Combine the individual overhead costs into a cost pool and calculate a predetermined overhead rate assuming the cost driver is number of units. b. Determine the cost of the 2,000 units of product made in January. c. Is the cost computed in Requirement b actual or estimated? Could Ware improve accuracy by waiting until December to determine the cost of products? Identify two reasons that a manager would want to know the cost of products in January. Discuss the relationship between accuracy and relevance as it pertains to this problem. LO 4-3 Exercise 4-5A Allocating overhead cost among products Tyson Hats Corporation manufactures three different models of hats: Vogue, Beauty, and Glamour. Tyson expects to incur $480,000 of overhead cost during the next fiscal year. Other budget information follows: Direct labor hours Machine hours Vogue Beauty Glamour Total 2,000 1,200 4,000 1,400 6,000 1,400 12,000 4,000 G A Use direct labor hours as the cost driver to compute the allocation rate and the budgeted overhead cost for each product. T Use machine hours as E the cost driver to compute the allocation rate and the budgeted overhead cost for each product. S Describe a set of circumstances where it would be more appropriate to use direct labor hours as the allocation base. , Required a. b. c. d. Describe a set of circumstances where it would be more appropriate to use machine hours as the allocation base. LO 4-3 D Exercise 4-6A Allocating E overhead costs among products Willey Company makes three A products in its factory: plastic cups, plastic tablecloths, and plastic ­bottles. The expected overhead costs for the next fiscal year include the following: N manager’s salary $210,000 D Factory Factory utility cost 70,000 R Factory supplies 20,000 Total overhead costs $300,000 A Willey uses machine hours as the cost driver to allocate overhead costs. Budgeted machine hours for the products are as follows:1 Required 1 2 3 T S Cups Tablecloths Bottles Total machine hours 300 Hours 750 950 2,000 a. Allocate the budgeted overhead costs to the products. b. Provide a possible explanation as to why Willey chose machine hours, instead of labor hours, as the allocation base. LO 4-3 Exercise 4-7A Allocating costs among products Fanya Construction Company expects to build three new homes during a specific accounting period. The estimated direct materials and labor costs are as follows: Cost Accumulation, Tracing, and Allocation Expected Costs Home 1 Home 2 Home 3 Direct labor Direct materials $40,000 30,000 $60,000 50,000 $100,000 80,000 Assume Fanya needs to allocate two major overhead costs ($80,000 of employee fringe benefits and $40,000 of indirect materials costs) among the three jobs. Required Choose an appropriate cost driver for each of the overhead costs and determine the total cost of each house. Round your figures to 3 decimal points. Exercise 4-8A Allocating to smooth cost over varying levels of production LO 4-3, 4-5 Production workers for Essa Manufacturing Company provided 300 hours of labor in January and 600 hours in February. Essa expects to use 5,000 hours of labor during the year. The rental fee for the manufacturing facility is $6,000 per month. Required Explain why allocation is needed. Based on this information, how much of the rental cost should be G in February? allocated to the products made in January and to those made A T Production workers for Chadwick Manufacturing Company provided 3,200 hours of labor in January and 2,800 hours in February. The company, whose operation isElabor intensive, expects to use 48,000 hours of labor during the year. Chadwick paid a $120,000 annual S premium on July 1 of the prior year for an insurance policy that covers the manufacturing facility for the following 12 months. , Exercise 4-9A Allocating to solve a timing problem LO 4-3 Required Explain why allocation is needed. Based on this information, how much of the insurance cost should Dmade in February? be allocated to the products made in January and to those E Exercise 4-10A Allocating to solve a timing problem A Erickson Air is a large airline company that pays a customer relations representative $8,000 per month. The representative, who processed 3,000 customer N complaints in January and 2,500 complaints in February, is expected to process 40,000 customer complaints during 2018. D Required R a. Determine the total cost of processing customer complaints in January and in February. A representative would or would not be b. Explain why allocating the cost of the customer relations LO 4-3 relevant to decision making. 1 affects a pricing decision Exercise 4-11A How the allocation of fixed cost LO 4-3 1 during the 2017 accounting period. The Arrow Manufacturing Co. expects to make 50,000 chairs company made 3,000 chairs in January. Materials and 2 labor costs for January were $36,000 and $48,000, respectively. Arrow produced 4,000 chairs in February. Material and labor costs for February 3 paid the $480,000 annual rental fee on its were $48,000 and $60,000, respectively. The company manufacturing facility on January 1, 2017. T Required S Assuming that Arrow desires to sell its chairs for cost plus 40 percent of cost, what price should be charged for the chairs produced in January and February? Exercise 4-12A Allocating joint product cost Ferrier Chemical Company makes three products, B7, K6, and X9, which are joint products from the same materials. In a standard batch of 150,000 pounds of raw materials, the company generates 35,000 pounds of B7, 75,000 pounds of K6, and 40,000 pounds of X9. A standard batch costs $600,000 to produce. The sales prices per pound are $6, $10, and $16 for B7, K6, and X9, respectively. LO 4-4 185 186 Chapter 4 Required a. Allocate the joint product cost among the three final products using weight as the allocation base. b. Allocate the joint product cost among the three final products using market value as the allocation base. Round your figures to 3 decimal points. LO 4-5 Exercise 4-13A Human factor Miriana Clinics provides medical care in three departments: internal medicine (IM), pediatrics (PD), and obstetrics gynecology (OB). The estimated costs to run each department follow: Physicians Nurses IM PD OB $600,000 80,000 $400,000 120,000 $500,000 160,000 Miriana expects to incur $450,000 of indirect (overhead) costs in the next fiscal year. Required a. Name four allocation bases that could be used to assign the overhead cost to each department. b. Assume the manager ofG each department is permitted to recommend how the overhead cost should be allocated to the departments. Which of the allocation bases named in Requirement a is the A manager of OB most likely to recommend? Explain why. What argument may the manager of OB use to justify his choiceTof the allocation base? c. Which of the allocationEbases would result in the fairest allocation of the overhead cost from the perspective of the company president? S overhead costs into separate pools could improve the fairness of the d. Explain how classifying ­allocation of the overhead , costs. Appendix LO 4-6 Exercise 4-14A Allocating D a service center cost to operating departments Conrad Corporation’s computer E services department assists two operating departments in using the company’s information system effectively. The annual cost of computer services is $600,000. The A 38 employees, and the sales department employs 22 employees. Conproduction department employs rad uses the number of employees as the cost driver for allocating the cost of computer services to N operating departments. D R Allocate the cost of computer services to operating departments. A Required LO 4-6 Exercise 4-15A A  llocating costs of service centers to operating departments— step method 1 Kirby Health Care Center, Inc. has three clinics servicing the Seattle metropolitan area. The compa1 supports the clinics. Moreover, its computer services department supny’s legal services department ports all of the clinics and2the legal services department. The annual cost of operating the legal services department is $200,000. The annual cost of operating the computer services department is 3 the number of patients served as the cost driver for allocating the cost of $360,000. The company uses legal services and the number T of computer workstations as the cost driver for allocating the cost of computer services. Other relevant information follows: S Number of Patients Sewell clinic 6,000 Alphretta clinic 4,200 Gwinnett clinic 5,800 Legal services Computer services Number of Workstations 18 16 18 8 10 Cost Accumulation, Tracing, and Allocation Required a. Allocate the cost of computer services to all of the clinics and the legal services department. b. After allocating the cost of computer services, allocate the cost of legal services to the three clinics. c. Compute the total allocated cost of service centers for each clinic. Exercise 4-16A A  llocating costs of service centers to operating departments— direct method LO 4-6 Quinlan Trust Corporation has two service departments: actuary and economic analysis. Quinlan also has three operating departments: annuity, fund management, and employee benefit services. The annual costs of operating the service departments are $480,000 for actuary and $800,000 for economic analysis. Quinlan uses the direct method to allocate service center costs to operating departments. Other relevant data follow: Annuity Fund management Employee benefit services Operating Costs* Revenue $500,000 900,000 600,000 $ 840,000 1,260,000 1,100,000 *The operating costs are measured before allocating service center costs. G A Required a. Use operating costs as the cost driver for allocating T service center costs to operating departments. b. Use revenue as the cost driver for allocating serviceE center costs to operating departments. S PROBLEMS—SERIES A , All applicable Problems in Series A are available in Connect. D Problem 4-17A Cost accumulation and allocation E Yalland Manufacturing Company makes two different products, M and N. The company’s two departments are named after the products; for example, Product A M is made in Department M. Yalland’s ­accountant has identified the following annual costs associated with these two products: N Financial data D Salary of vice president of production division $160,000 R Salary of supervisor Department M 80,000 Salary of supervisor Department N 60,000 A Direct materials cost Department M Direct materials cost Department N Direct labor cost Department M Direct labor cost Department N Direct utilities cost Department M Direct utilities cost Department N General factorywide utilities Production supplies Fringe benefits Depreciation Nonfinancial data Machine hours Department M Machine hours Department N 1 1 2 3 T S 300,000 420,000 240,000 680,000 120,000 24,000 36,000 36,000 138,000 600,000 5,000 1,000 Required a. Identify the costs that are (1) direct costs of Department M, (2) direct costs of Department N, and (3) indirect costs. b. Select the appropriate cost drivers for the indirect costs and allocate these costs to Departments M and N. LO 4-1, 4-2, 4-3 CHECK FIGURE c. Product N: $522.55 187 188 Chapter 4 c. Determine the total estimated cost of the products made in Departments M and N. Assume that Yalland produced 2,000 units of Product M and 4,000 units of Product N during the year. If ­Yalland prices its products at cost plus 40 percent of cost, what price per unit must it charge for Product M and for Product N? LO 4-1, 4-2, 4-3 Problem 4-18A Selecting an appropriate cost driver (What is the base?) The Huffman School of Vocational Technology has organized the school training programs into three departments. Each department provides training in a different area as follows: nursing assistant, dental hygiene, and office technology. The school’s owner, Amy Huffman, wants to know how much it costs to operate each of the three departments. To accumulate the total cost for each department, the accountant has identified several indirect costs that must be allocated to each. These costs are $12,000 of phone expense, $21,000 of office supplies, $900,000 of office rent, $144,000 of janitorial services, and $150,000 of salary paid to the dean of students. To provide a reasonably accurate allocation of costs, the accountant has identified several possible cost drivers. These drivers and their association with each department follow: Cost Driver Number of telephones Number of faculty members Square footage of G office space Number of secretaries A Department 1 Department 2 Department 3 20 20 14,000 2 30 16 8,000 2 50 24 14,000 2 T Required E a. Identify the appropriateScost objects. b. Identify the appropriate cost driver for each indirect cost and compute the allocation rate for as, to the cost objects. signing each indirect cost c. d. e. f. g. LO 4-1, 4-2, 4-3 CHECK FIGURE b. To NY: $1,080 Determine the amount of telephone expense that should be allocated to each of the three departments. Determine the amount of supplies expense that should be allocated to Department 3. D Determine the amount of office rent that should be allocated to Department 2. Determine the amount E of janitorial services cost that should be allocated to Department 1. Anot listed here that could be used to allocate the cost of the dean’s salary Identify two cost drivers to the three departments. N Problem 4-19A Cost allocation in a service industry D Eagle Airlines is a small airline R that occasionally carries overload shipments for the overnight delivery company Never-Fail, Inc. Never-Fail is a multimillion-dollar company started by Wes Never immediAhis first accounting course. The company’s motto is “We Never-Fail to ately after he failed to finish Deliver Your Package on Time.” When Never-Fail has more freight than it can deliver, it pays Eagle to carry the excess. Eagle contracts with independent pilots to fly its planes on a per-trip basis. Eagle 1 that cost the company $6,000,000. The plane has an estimated useful recently purchased an airplane life of 20,000,000 miles and 1 a zero salvage value. During the first week in January, Eagle flew two trips. The first trip was a round trip flight from Chicago to San Francisco, for which Eagle paid $350 2 The second flight was a round trip from Chicago to New York. For this ...
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