Module 10 Allocating Costs to Jobs and Processes

Module 10 – Allocating Costs to Jobs and Processes

10.1 Introduction  It is only through the understanding the details of cost gathering and allocation that managers can review alternative systems which may be more in tune with their objectives  This module concentrates on the tracking and controlling functions of cost systems – only when managers are aware of how these requirements are satisfied will they be in position to assess their informational needs for planning and choosing

10.3.1 Where do Materials Costs come from?  Materials are drawn from inventory and this action triggers the raising of a stores requisition slip  On this slip is quantity and time the withdrawal took place, but not price – this would be too time consuming to work out for each slip  Instead of the stores people tracking the purchase price of each item of material, a standard price would be used over say three months that would attempt to take into account price fluctuations  Any differences between actual purchase price and standard price would be accounted for in P&L at end of the given period

10.3.2 Where do Labor Costs come from?  For each identifiable cost item a time record would be attached on which each individual working directly on the job would enter the time spent  When different workers receive different hourly rates of pay for working on the same cost item, a standard wage rate is used (similar to standard price for materials, above)

10.3.3 Where do Overhead costs come from?  Both Manufacturing and Non-Manufacturing costs are indirect as they cannot be linked directly to the outputs of production  Manufacturing Overheads include – supplies of low value high use components such as screws, glue; factory heating and lighting, machine maintenance and depreciation  Non-Manufacturing Overheads include administration, selling and distribution, bank interest, managerial salaries  Overhead cost must first be gathered into cost centers – pockets of activity for which individual managers may be held responsible  A expenditure level would be set for each cost center beyond which an individual manager may not go without approval  Allocating overhead cost is more difficult than gathering it – accountants use a predetermined overhead rate to spread overheads across the units of production:

Predetermined Overhead Rate = Budgeted Overhead for Accounting Period Budgeted Production Units Example: A business sells one product which contains $5 direct material and $10 direct labor. The plan is to manufacture 10,000 units of the product and the estimate of total overheads is $100,000. The predetermined overhead rate = $100,000/10,000 = $10 per unit. So:

Cost Profile for product ($) Direct Material 5 Direct Labor 10 Share of Overhead 10 Total Cost 25

 Difficulties arise when a company is producing multiple products which each consume different proportions of the factors of production including overhead  Cost accountants then search for causal factors or activity bases – the one factor which prompts the incidence of most of the headings of cost which make up overhead  Examples of activity bases include direct labor hours (used where the overhead is people related) or machine hours (used where machines have replaced people)  The resulting predetermined rate (expressed in terms of the activity base) is applied to individual products using these products’ consumption of the causal factor.

Example: Same example as above, let’s use direct labor hours as the causal factor. The business plans to spend 25,000 direct labor hours next year and that this product (one of several) takes 2 hours to construct by direct labor staff. Predetermined overhead rate = 100,000/25,000 = $4 per Direct Labor Hour {Note: this overhead rate applies to all products, not just this one} Share of overhead = 2 hours x $4/hour = $8 per unit

Cost Profile for product ($) Direct Material 5 Direct Labor 10 Share of Overhead 8 Total Cost $23

 It is virtually impossible to estimate accurately the total overheads for next year (the $100,000) and the level of production expressed in terms of the activity base (the 25,000). The difference between actual and planned overhead is accounted for in the P&L Example: Lets say in the example above the actual overhead figure was $105,000 and that production was equivalent to 26,000 direct labor hours: Overhead applied to products = 26,000 x $4 = $104,000 Actual Overhead = $105,000 Underapplication charged to P&L as an increase in cost of goods: $1000

10.4 Plantwide versus Departmental rates  It is unrealistic to assume that one activity base can explain more than a handful of overhead costs, far less the majority or them  For example, direct labor hours may be a good activity base for supervision costs but it is not good for selling and distribution costs  Departmental overhead rates allocate overheads to particular departments and then identify the activity base for each department

Example: Three service depts and two production depts are used to manufacture heavy lifiting gear. Here are their cost estimates for next year:

Overhead ($) Square Meters No. of Service Hours Occupied employees Forging 252,500 4500 50 450 Welding 113,750 3000 100 75 Personnel 218,000 1800 30 225 Computing 100,750 12,000 20 4500 Site Maintenance 73,500 16,500 10 1500 758,500 37,800 210 6750

 The aim of overhead cost allocation is to apply costs to the products of the business  Since cost flow through production depts and not service depts, the first step is to transfer service dept costs to production dept so as to attach them to products  The are two main methods of doing this – direct and step methods

10.4.1 The Direct Method  In the direct method of overhead allocation, costs for each of the service depts are emptied out into the production depts and added to the overheads already there to calculate two predeteremined overhead rates  Take each service dept and use a suitable activity base to allocate its overhead costs to the two production depts - Personnel: number of employees (Forging: 50, Welding: 100) - Computing: service hours (Forging: 450, Welding: 75) - Site Maintenance: square meters occupied (Forging: 4500, Welding:3000)  Now empty overhead costs from service dept into production Forging Welding Personnel Computing Site Total Maintenance Initial 252,500 113,750 218,000 100,750 73,500 758,500 Allocation Personnel 72,667 145,333 (218,000) 0 Computing 86,357 14,393 (100,750) 0 Site 44,100 29,400 (73,500) 0 455,624 302,876 0 0 0 758,500

Allocating Personnel: 50/150 x 218,000 (72,667) goes to Forging, 100/150 x 218,000 (145,333) goes to Welding Allocating Computing: 450/525 x 100,750 ($86,357) to Forging , 75/525 x 100,750 ($to Welding Allocating Site Maintenance: 4500/7500 x 73,500 ($44,100) to Forging, 3000/7500 x 73,500 ($29400) to Welding

 Now find the predetermined overhead rates for Forging and Welding. It has been decided that machine hours activity rate for Forging and a direct labor hours rate for Welding. The total machine hours is planned to be 45,000 while the direct labor hours will be 100,000.

Forging predetermined overhead rate is 455,624/45,000 = $10.12 per machine hour Welding predetermined overhead rate is 302,876/100,000 = $3.02 per direct labor hour

 For every order which goes through Forging, $10.12 overhead will be added for every machine spent on the order. When the order moves to Welding $3.02 will be added for every direct labor hour spent on it during the Welding process

10.4.2 The Step method of overhead allocation  The direct method ignores the inter-departmental services provided by each service dept – e.g. personnel not only service forging and welding but also computing  The step method selects service depts in descending order of magnitude of overhead expense and allocates their overheads across all other depts – production and service

Forging Welding Personnel Computing Site Total Maintenance Initial 252,500 113,750 218,000 100,750 73,500 758,500 Allocation Personnel 60,556 121,111 (218,000) 24,222 12,111 0 Computing 27,772 4,628 - (124,972) 92,572 0 Site 106,910 71,273 - - (178183) 0 447,738 310,762 0 0 0 758,500 Allocating Personnel: Always ignore the a dept’s consumption of its own resources, hence the denominator is 180 not 210. Forging is 50/180 x 218,000 ($60,556), Welding is 100/180 x 218,000 ($121,111)……… Allocating Computing: Once a service dept is closed down, no more allocations are given to it, therefore the denominator for total number of service hours becomes 6750– 4500-225 = 2025. Also, the total overhead is the computing dept’s original overhead plus that allocated to it by personnel = $100,750 + $24,222 = $124,972 Forging = 450/2025 x $124,972 ($27,772), Welding is 75/2025 x $124,972 ($4,628), Site Maintenance is 1500/2025 x $124,972 ($92,572) Allocating Site Maintenance: Forging = 4500/7500 x 178183 = $106,910, Welding = 3000/7500 x 178183 =$71,273

 Finally, calculate the perdetermined overhead rate for Forging and Welding using machine hours and direct labor as the respective activity bases: Forging: 447,738/45,000 = $9.95 per machine hour Welding: 310,762/100,000 = $3.11 per direct labor hour

 Consider two jobs going through both production depts: Forging Welding Job 101 50 machine hours 150 direct labor hours Job 247 150 machine hours 50 direct labor hours using the direct method, what would the allocation of overhead be? Forging Welding Total Job 101 50 x $10.12= $506 150 x $3.02 =$453 $959 Job 247 150 x $10.12=$1518 50 x $3.02 = $151 $1669 using the step method what would the total allocation be for each job? Forging Welding Total Job 101 50 x $9.95 = $498 150 x $3.11=$467 $965 Job 247 150 x $9.95=$1493 50 x $3.11 = $156 $1649

 In the above example, the difference in the allocation of overhead cost would not warrant using the more complex step method  To ensure overhead falls on the correct product, management needs to install cost systems which are capable of regular review and which can be updated to reflect changes in resource usage by products

10.5 Joint Products and By-Products  A joint product appears during the processes involved in producing the main product  If management has the option of not allowing the second product to emerge from the process the two products are not joint  How can production costs be split over the two or more products which appear from the production process? Exa mple: A chemical process produces Chemical A and Chemical B. Both can be sold at the point they emerge from production. Total cost of process = $100,000. Chemical A – 10,000 tons, sales value $8 per ton. Chemical B – 5000 tonnes, sales value $10 per ton.

They are four main methods of joint cost allocation: 1. Equal Shares  Both joint products have an equal share of the total cost of production

Chemical A Chemical B Total Sales Value1 $80,000 $50,000 $130,000 Joint Production Costs $50,000 $50,000 $100,000 $30,000 - $30,000

2. Physical Characteristics This method assumes that physical characteristic such as weight, volume or difficulties in handling cause certain costs to be incurred. The method assumes a linearity between the characteristic and the cost. In this case we will use weight – 10,000 tons vs. 5000 tons means a cost ratio of 2:1

Chemical A Chemical B Total Sales Value1 $80,000 $50,000 $130,000 Joint Production Costs $66,666 $33,333 $100,000 $13,334 $16,666 $30,000

3. Sales Value at Split Off Reflects the ability of the product to bear costs by using the money generated by each product – A : B = 80,000:50,000 = 8:5 = 0.61538 : 0.38461

Chemical A Chemical B Total Sales Value1 $80,000 $50,000 $130,000 Joint Production Costs $61,538 $38,461 $100,000 $18,462 $11,539 $30,000

4. Ultimate Net Sales Method  It is an extension of the Sales Value at Split Off method – it recognizes that a business may want to process the two products further after split off to maximize profit  New Information – Chemical A: further processing of $20,000 creates a new sales value of $12 per ton. Chemical B: further processing of $5000 creates a new sales value of $12 per ton  The Ultimate Net Sales method deducts the new processing costs from the ultimate sales value and allocates joint costs on the net amount: Chemical A Chemical B Total Ultimate Sales Value $120,000 ($12x10000) $60,000($12x5000) $180,000 New Costs $20,000 $5,000 $25,000 Ultimate Net Sales value $100,000 $55,000 $155,000 Joint Production Costs $64,516 $35,484 $100,000 $35,484 $19,516 $55,000

Note: we are allocating the joint production costs based on the Ultimate Net Sales value for each chemical, i.e. the allocation ration is 100,000 : 55,000 or 0.64516: 0.35484

 Since the method of allocation does not effect overall cost or sales revenue of each product, why does the method of allocation matter? 1. Product Management needs to plan what resources need to allocated to which products based on the costs each of the products has already incurred 2. The business must attribute a value to the cost of goods sold (P&L) and the cost of goods unsold (closing stock in Balance Sheet) 3. For price setting – some contracts stipulate that businesses are allowed to charge a fixed mark up on proven cost of production

10.5 (Continued) By Products:  A By-Product is one which emerges from a production process that is designed to produce another product  Production and Managerial effort is devoted to the main product but another product emerges at the same time that has a low sales value relative to the main product

Example: A timer operation produces 72 meters of planks @$1 sales value per meter. At the same time a by product emerges from the production process of timber ends and trimmings which have a total sales value of $10. The total costs of the process is $30

 In this case, no attempt is made to allocate the costs of production between the two products  Instead revenues generated from the ends and trimmings would be deducted from the costs of processing before determining the gross margin from operations:

Sales revenue 72 Cost of Sales: Production Costs 30 Less: Revenue from by-product 10 20 Gross Margin 52

 By-Products can change into joint products, e.g. modest trimming costs could greatly enhance the sales value of the ends and trimmings

10.6 Process Costing  Job Costing is used where individual products are deemed to be separate jobs which incur separate costs  Job costing is operated in enterprises where relatively small numbers of high value tasks are undertaken during the accounting period (e.g. construction, aerospace) or where the outputs can be batched in larger units for costing purposes – e.g. in the PC industry you can have 300 units with a color monitor and then another 500 without  Process costing is used where no uniqueness is identifiable in the products produced and where the process is almost continuous (e.g. chemical, brewing)

10.7 Process Costing and the Equivalent Unit  In job costing, indirect costs (and possibly direct material and labor costs) are averaged over units produced  Process costing also uses averaging, but the problem is how many units have been produced over an accounting period?  Work in progress at the beginning and end of the process may be in different states of completion – and because the process is continuous you don’t know what state they are in as you would in the job situation  Accountants use an equivalent unit of production to overcome the difficulties in measuring production – an equivalent unit of production is an assessment of the degree of completion of a unit under each major component of cost

Examples: 1. At the end of the financial year a company had completed the production of 12 million liters of paint. On the last day the production director assessed that 4 million liters were in production but that they were one quarter finished. The equivalent units of production amount to: 12 million + 4 million/4 = 13 million equivalent units

This figure would then be used to divide into the total cost of production to determine the cost per equivalent unit.

2. The same as above, except that of the 12 million liters completed during the year, 2 million were in the opening work in progress at the beginning of the year, each liter being half finished. How many equivalent units were produced during the year? 2 million/2 + 10 + 4 million/4 = 12 million.

3. reverting to 1. above, imagine all chemicals required were introduced at start of process and that direct labor and other conversion effort were applied evenly throughout the process. The equivalent unit calculation now has to be broken in two parts: material and labor & conversion Material Labor & Conversion Units started and completed 12 million 12 million Closing work in progress 4 million 1 million Equivalent units of production 16 million 13 million

Material input is complete – 16 million liters total was inputted into the process Labor & Conversion – work was input into the process such that 12 million liters was completed and 1 million was left in closing stock So in calculating the costs per liter of paint this year, material costs will be divided by 16 million and the labor and other conversion costs will be divided by 13 million.

4. Reverting to 2. above: of the 12 million liters completed during the year, 2 million were in the opening work in progress at the beginning of the year, each liter being half finished. Imagine that opening work in progress had all material input added in the previous year and that only labor and conversion have to be made during the early days of this accounting year: Material Labor & Conversion Opening Work in Progress 0 1 million Units Started and Completed 10 million 10 million Closing work in progress 4 million 1 million Equivalent units of production 14 million 12 million

Self Test on Equivalent Units: (Page 10/19)

Material Labor & Conversion Opening Work in Progress 1500 500 Units Started and Completed 7000 7000 Closing work in progress 1500 750 Equivalent units of production 10000 8250

Note: the opening WIP had to be finished by using 1500 equivalent units from material and 500 from labor – so the equivalent units comprise of the amount that has yet to be finished.

10,000 units were inputted during June and at the end of the month only 3000 were left as closing stock, hence 7000 were started and completed. The 3000 is subtracted only from the 10,000 inputted into the process because the 2000 units that were in opening work in progress were completed and sold. This example assumes FIFO – i.e. the opening stock is the first to be sold. So the 2000 opening stock could not be part of the 3000 partially completed units that made up closing stock.

10.8 Cost per Equivalent Unit  Process costing calculates the cost per unit of production  This information is required not only for planning and controlling purposes but for valuing end of period inventory for financial accounting and reporting.  To do this, we must first calculate the number of units that have been produced – this is achieved by using equivalent units, whereby partially completed units are converted into equivalent whole units  Then costs must be allocated to these equivalent units  Costs to be accounted for by a production activity in any accounting period comprise two parts: (i) those attaching to opening work in progress at the beginning of the period but which were incurred in the previous period (ii) those costs incurred during this accounting period in order to finish the opening work in progress, make units started and completed in the period start work on the units left in the process at the end of the period

Example: we use scenario 4 from previous section: Of the 12 million liters completed during the year, 2 million were in the opening work in progress at the beginning of the year, each liter being half finished. Imagine that opening work in progress had all material input added in the previous year and that only labor and conversion have to be made during the early days of this accounting year:

Equivalent Unit Statement Material Labor & Conversion Opening Work in Progress 0 1 million Units Started and Completed 10 million 10 million Closing work in progress 4 million 1 million Equivalent units of production 14 million 12 million

Let’s assume the following costs for the year, with conversion costs assumed to be all direct and indirect overhead incurred by the production process:

Material ($m) Labor & Conversion($m) Total ($m) Value of opening WIP 0.8 0.9 1.7 Incurred during the year 7.0 12.0 19.0 Total Cost to account for 7.8 12.9 20.7

Now we must work out the cost per equivalent unit using above costs and the equivalent unit statement Material Labor & Conversion

Cost for current period $7 m $12 m Equivalent units of production 14 million 12 million Cost per Equivalent cost of production $0.50 $1 Total Cost per equivalent unit $1.50

{Note: this method (FIFO) concentrates only on cost incurred this year}

Now we have to allocate the costs to production using cost per equivalent unit and the equivalent unit statement above Material($m) Labor & Conversion ($m) Total($m) Opening WIP 0 1 1 Units Started & Completed 5 10 15 Closing WIP 2 1 3 7 12 19

The value of units shipped out is: Previously incurred cost of opening WIP $1.7m Costs to complete opening WIP $1.0m Units started and completed $15m $17.7m This is where FIFO comes in, it assumes that all the opening stock completed was the first to be sold.

Now to calculate the value of closing inventory: Value of closing stock = total costs incurred during year – costs of units shipped out = $20.7m - $17.7m = $3m

 The costing procedure above is known as First in First Out (FIFO) process costing because it assumes that the opening work in progress is worked on first and transferred to finished goods before work starts on this period’s production. It ignores the effort expended on production last year but instead gives the current period’s costs precisely as they occurred

 Sometimes rather than looking at a whole year you might want to look at a smaller time frame – like four weeks. In this case we add the costs incurred last year in producing this years opening work in progress to the costs of the current period and a weighted average cost is calculated as below:

Here was the old Equivalent Units Statement using the above FIFO method: Material Labor & Conversion Opening Work in Progress 0 1 million Units Started and Completed 10 million 10 million Closing work in progress 4 million 1 million Equivalent units of production 14 million 12 million

But in the weighted average method we include all the costs incurred last year in producing this years opening stock so we must include last years equivalent units in this years statement: Material Labor & Conversion Opening Work in Progress 2 million 2 million Units Started and Completed 10 million 10 million Closing work in progress 4 million 1 million Equivalent units of production 16 million 13 million Here are the costs taken from the FIFO example above:

Material ($m) Labor & Conversion($m) Total ($m) Value of opening WIP 0.8 0.9 1.7 Incurred during the year 7.0 12.0 19.0 Total Cost to account for 7.8 12.9 20.7

In calculating the cost per equivalent unit we now include the costs incurred last year in producing this years opening stock: Material Labor & Conversion

Total Cost $7.8 m $12.9 m Equivalent units of production 16 million 13 million Cost per Equivalent cost of production $0.4875 $0.9923 Total Cost per equivalent unit $1.4798

Now lets allocate this cost per equivalent unit to production

Material $m Labor & Conversion Total Opening Work in Progress 0.975 1.9846 2.9596 Units Started and Completed 4.875 9.923 14.798 Closing work in progress 1.95 0.9923 2.9423 Equivalent units of production 7.8 12.899 20.6999

Cost of units sold = Opening WIP + Units started and completed = $2.9596 m + $14.798 m = $17.7576 m

Value of Closing Stock = Total Cost – cost of units sold = $20.7m - $17.7576m = $2.9424m

 The weighted average smoothes changes in the costs of production by including the costs from last year

10.9 Activity Based Costing (ABC)  It’s been used in some organizations as an alternative to traditional costing techniques  Activity based costing focuses on the assumption that activities (e.g. production planning, quality inspection) rather than products cause costs to be incurred and that products consume activities (and therefore costs)  In ABC, there is a de-coupling of costing from financial accounting – the cost of products is the principal goal, not inventory valuation  Different activities have different cost drivers (=causal factors)  ABC embraces all overhead, not just overhead surrounding the production process  By using multiple cost drivers, ABC reflects the complexity of production and marketing

10.10 Traditional Costing versus ABC  Activity based information has been found to be more useful in manufacturing environments when diverse customized products are produced in low volumes  In these environments there are no ‘fixed costs’, although traditional costing would say there is. For example, increasing product diversity means more information technology and more sophisticated machines. In traditional cost accounting, these costs would be added to overhead and allocated using something like direct labor hours. But these costs aren’t caused by direct labor hours increasing, they are because of the decision to pursue product diversity.

Example of ABC vs Traditional: Four products produced using same plant and equipment and similar production process

Quantity Units of Direct Labor Machine Manufactured Material hours per unit Hours per unit Forth 10 8 1 10 Tay 100 6 2 6 Spey 1000 4 3 4 Tweed 10,000 2 4 1

Units of Direct Machine Quality Computing Training Material labor Hours Control % Center % % hours Forth 80 10 100 70 40 10 Tay 600 200 600 10 30 10 Spey 4000 3000 4000 10 20 10 Tweed 20,000 40,000 10,000 10 10 70 Total 24,680 43,210 14,700 100% 100% 100% Value of $58,800 $10,000 $10,000 $10,000 Resource

Traditional Method: Total Overhead Costs: $88,800 Total Direct Labor: 43,210 hours Overhead Cost per hour: $2.055

Allocate these costs to each product Forth $2.055 x 1 hour = $2.055 per unit Tay $2.055 x 2 hour = $4.11 per unit Spey $2.055 x 3 hour = $7.65 per unit Tweed $2.055 x 4 hour = $8.22 per unit ABC Method: Break down the costs for each product based on the activities that contributed to final delivery of the products.

Machine Quality Computing Training Total ($) Hours ($) Control Center ($) ($) ($) Forth 400 7000 4,000 1000 12,400 Tay 2400 1000 3000 1000 6400 Spey 16000 1000 2000 1000 20,000 Tweed 40000 1000 1000 1000 43,000 Total 58800 10,000 10000 1000 88,800

Note: Forth – Machine Hours = 100/14700 x $58800 = $400, similar for the rest

Overhead per unit Forth: 12,400/10 = $1240 Tay: 6400/100 = $64 Spey: 20,000/1000 = $20 Tweed: 43,000/10,000 = $4.30

 Note the difference in overhead per unit between traditional and ABC – $2.055 and $1240 for Forth respectively. This is because traditional understates low volume and overstates high volume products

Case Study (Page 10/29):

Islay Mull Skye Total Monthly Output 10,000 8000 3000 (Units) Direct Material $18 $15 $8 $324,000 Cost per unit Direct Material 3 3 8 usage per unit Direct Labor $6 $8 $5 cost per unit Direct Labor 2 3 1 47,00 hours per unit

Note: $324,000 = $18 x 10,000 + 8000x $15 + 3000 x $8 $47,000 = 10,000 x 2 + 8000 x 3 + 3000 x 1 Currently the following overhead costs are allocated to products on the basis of direct labor hours: $ Machine Setup 20,000 Machine Energy and maintenance 182,000 Production Schedule 125,000 Packing and Shipping 61,000 Design and Development 80,000 468,000

The engineer in charge of production says the number of switches from one line to another costs a packet. The maintenance engineer says his costs are driven by machine hours The production scheduler says its the number of orders they received that drive his costs. The packing foreman says it’s the number of shipments Design Director says it’s the number of designs accepted into production.

The information that you get from these conversations is as follows: Islay Mull Skye Total No. production 3 6 18 27 runs Machine hours 2 1 3 37,000 per unit No. of 6 2 17 25 shipments No. of accepted 6 3 10 19 designs No. of goods 9 18 144 171 inwards orders

Note: 37,000 = 2 x10,000 (output in units) + 1 x 8000 + 3 x 3000

What is the Cost per unit under the current costing scheme? Total Overhead to be allocated = $468,000 Total number of direct labor hours = 47,000 Allocating Overhead by direct labor hours : 468,000/47,000 = $9.95 / direct labor hour

Per product cost = direct material per product + direct labor per product + allocated overhead per product

Per unit product cost of Islay: $18 + $6+ ($9.95 x 2) = $43.90 for one unit of Islay Per unit cost of Mull: $15 + $8+ ($9.95 x 3) = $52.85 for one unit of Mull Per unit cost of Skye: $8 + $5 + ($9.95 x 1) = $$22.95 for one unit of Skye

What would the cost be under ABC?

In ABC, we get the cost driver for each overhead and then costs are allocated to products based on their usage of that activity

Machine Setup : $20,000/27 setups = $740.74 per machine setup Machine Energy & Maintenance: $182,000/37,000 machine hrs= $4.92 per machine hour per unit Production Scheduling: $125,000/171 inward orders = $731 per inward order Packaging and Shipping: $61,000/25 shipments = $2,440 per shipment Design and Development: $80,000/19 accepted designs = $4,210 per accepted design

Now allocate these activity costs to each product unit in accordance with their usage:

Islay: (3 x $740.74)/10,000 + 2 x $4.92 + ($731 x 9 )/10,000+ ($2440 x 6)/10,000 + ($4210 x 6)/10,000 = $0.22 + $9.84 + $0.66 + $1.46 + $2.526 = $14.71/unit Total Product Cost = $18 + $6 + $14.71 = $38.71

Mull: ($740.74 x 6)/8000 + ($4.92 x 1) + ($731 x 18)/8000 + ($2440 x 2)/8000 + ($4210 x 3)/8000 = $0.55 + $4.92 + $1.64 + $0.61 + $1.58 = $9.30 / unit Total Product Cost = $15 + $8 + $9.30 = $18.30/product unit

Skye: ($740.74 x 18)/3000 + $4.92 x 3 + ($731x144)/3000 + ($2440 x 17)/3000 + ($4210 x 10)/3000 = $4.44 + $14.76 + $35.09 + $13.83 + $14.03 = $82.15/ unit Total Product Cost = $8 + $5 + 82.15 = $95.15/product unit

Note: $14.71 x 10000 + 9.30 x 8000 + 82.15 x 3000 = $147,000 + $74,400 + $246,450 = $467,850, which almost equals the total overhead cost we were given of $468,000.

Comparison of unit costs:

Islay Mull Skye Traditional Direct 43.90 52.85 22.95 Labor Hours ABC Method 38.71 18.30 95.15

 Old Method is volume related, high volume items are asked to carry more than their fair share  Volume related overhead bases such as direct labor hours would only be suitable in cases where overhead varies directly with production output  Islay and Mull are subsidizing Skye  You can use more than one cost driver to allocate overhead – in the above example we could use the value direct materials as a base to allocate production scheduling overhead while using machine hours for the rest of the overhead: Production Scheduling = $125,000/$324,000 = $0.38 / $ spend on direct materials Other overhead = ($468,000 - $125,000)/47,000 = $7.30/machine hour

Note: he uses 37,000 as the denominator, mistake?

These make product costs approach but not each their correct ABC level.

Review Questions: 1. b 2. c 3. False 4. d 5. d 6. False 7. c 8. a 9. c 10. d 11. b 12. c 13. b 14. d 15. True 16. d 17. Personnel – use number of employees as an activity base: Moulding Dept overhead from personnel = 45/80 x $50,000 = 28125 = c 18. Machining o/h from Stores = 20,000/100,000 x $25,000 = $5000 = a 19. Overhead from Stores to Moulding = 80,000/100,000 x $25,000 = $20,000 Total Overhead for Moulding = $400,000 + $28,125 + $20,000 = $448,125 Overhead allocation rate = 448,125/65,000 = $6.89 / direct labor hour = b 20. Overhead from personnel to machining = 35/80 x$50,000 = $21,875 Total overhead = $325,000 + $5000 + $21,875 = $351,875 Allocation rate = 351,875/45000 = $7.82 = d 21. Total cost in Binding dept = $235 + $110 + 150% of $100 = $510 = c 22. Total cost in Printing = $375 + $75 + $5.80 x 20 = $566 Total ‘cost of job = $566 + $510 = $1076= d 23. Sales value allocation means that their costs are shared according to their sales revenue: Total Revenue = 10000 (0.5) + 40,000 (0.1) = 5000 + 4000 =$9000 Loaves share of cost = 5000/9000 x $5400 = $3000 = c 24. Cost of 10,000 loaves = $5400 x 10000/50000 = $1080 Cost of one loaf = $1080/10,000 = $0.11; Profit = $0.50 - $0.11 = $0.39 per loaf $0.39 x 10,000 = $3900 = d 25. Sales revenue for rolls = $4000, Revenue for loaves = $5000 Take away new costs for rolls: $4000 - $0.02 x 40,000 = $3200 Take away new costs for loaves: $5000 - $0..1 x 10,000 = $4000 Now distribute costs to rolls on the ratio of net revenue = 3200/7200 x $5400 = $2400 = a 26. a 27. False 28. d 29. b 30. c 31. Equivalent Units Statement Materials Labor Opening Work in Progress 3750 2000 Started & completed 11000 11000 Closing WIP 2000 3000 16,750 16,000

Ans: b

32. c 33. Weighted Average is being applied hence the effort in producing March’s opening work in progress is included

Equivalent Units Statement Materials Labor Opening Work in Progress 2600 2600 Started & completed 94001 94001 Closing WIP 1800 1080 13,800 13,080

1 12,000 was transferred to finished goods but 2600 of that came from work started before March year so only 12000 – 2600 = 9400 was actually started and completed during March Ans: d 34. If this were FIFO we would only consider costs incurred in March when working out cost per equivalent unit, but in weighted average we take into account costs incurred before March : Materials Labor Opening WIP costs 7800 10200 During March 37,050 61,740 44,850 71,940 Cost per Equivalent Unit : Materials = 44,850/13800 = $3.25 per kilo Labor = 71,940/13080 = $5.50 per kilo Total cost per equivalent unit = $8.75 Cost of WIP at end of March = 1800 x 3.25 + 1080 x $5.50 = $11,790 = c 35. Cost of goods started & finished in March= 9400 x $3.25 + 9400 x $5.50 = $82,250 Cost of goods finished from opening WIP = 2600 x $3.25 + 2600 x $5.50 = $22,750 Total = $82,250 + $22,750 = $105,000 = c 36. FALSE 37. b 38. a 39. a 40. c 41. TRUE 42. Total Overhead = 35 + 60 + 130 + 250 + 115 = $590,000 Total direct labor hours = 3200 x 6 + 475 x 4 + 155 x 2 = 21410 Overhead allocatio rate = 590,000/21,410 = $27.56 /direct labor hour = d 43. Total Machine Hours = 3200 x 20 + 475 x 8 + 155 x 3 = 68265 Allocation Rate = 590,000/68,265 =$8.64/machine hour = c 44. Overhead Cost / printer = $27.56 x 4 = $110.24= d 45. $8.64 x 3 = $25.92 = b 46. Monitor overhead total = 50% of 35,000 + 30% of 60,000 + 20% of 130,000 + 45% of 250,000 + 40,000/115,000 x $115,000 = $214,000 Overhead cost per monitor = $214,000/3200 = $66.88/monitor = c 47. Plotter Overhead total = 30% of 35,000 + 10% of 60,000 + 35% of 130,000 + 20% of 250,000 + 40,000/115,000 x $115,000 = $152,000 Overhead cost per plotter = $152,000/155 = $980.65 per plotter = d 48. Overhead cost per printer is $110.24 by traditional method Total Overhead cost of printer = 20% of 35,000 + 60% of 60,000 + 45% of 130,000 + 35% of 250,000 + 35,000/115,000 x $115,000 = $224,000 Overhead Cost per printer using ABC = $224,000/475 = $471.58 per printer Difference is $471.58 - $110.24 = $361.34 = b 49. False 50. True Case Study 10.1 1. First allocate the unallocated indirect costs:

 Rent/Rates : the cost driver is Area, total area = 60,000; total Rent/Rates= $24,000 Personnel’s share: 5,000/60,000 x $24,000 = $2000 Maintenance’s share: 5000/60,000 x $24,000 = $2000 …..similar for the rest  Power (machines): cost driver is machine hours, total machine hours = 90,000; total overhead = $18,000 Fabrication’s share: 50,000/90,000 x $18,000 = $10,000 …..  Depreciation: cost driver is plant value; total = $150,000; total overhead to be allocated = $15,000 Personnel = 4000/150,000 x$15,000 = $400 …..  Heat & Light: cost driver is area :total = 60,000 sq mts; overhead to be allocated = $12,000 Personnel: 5000/60,000 x $12,000 = $1000 ….

Personnel Maintenance Catering Fabrication Welding Total Rent/Rates 2000 2000 6000 8000 6000 24,000 Power - - - 10,000 8,000 18,000 (Machines) Depreciation 400 900 800 7500 5400 15,000 Heat & Light 1000 1000 3000 4000 3000 12,000 Total 3400 3900 9800 29,500 22,400 69,000 Previously 100,000 75,000 60,000 300,000 200,000 735,000 Allocated Final Total 103,400 78,900 69800 329,500 222,400 1804,00 1 This is the total plantwide overheadStep Method: Need to close down service depts in the order of their share of total overhead, so personnel first

Personnel Maintenance Catering Fabrication Welding Total Initial 103,400 78,900 69800 329,500 222,400 Allocation (103,400) 10,340 10,340 51,700 31,020 - 89,240 80,140 381,200 253,420 (89,240) 0 49,578 39,662 80,140 430,778 293,082 (80,140) 50,087 30,053 480,865 323,135

Notes:  Allocate Personnel using number of employees as the cost driver: total (not including personnel) = 100. So maintenance’s allocation would be 10/100 x $103,400 = $10,340. Similar for the rest.  Allocate Maintenance using machine hours as the cost driver; total machine hours = 90,000 so fabrications share is 50,000/90,000 x $89,240 = $49,578  Allocate Catering using employees as the cost driver; total employees (not including personnel or maintenance) = 90; so fabrication share of catering overhead = 50/80 x $80,140 = $50,087 use machine hours as the causal factor in production overhead Overhead rate for fabrication = $480,865/50,000 = $9.62 per machine hour Overhead rate for welding = $323,135/40,000 = $8.08 per machine hour

2. Total Plantwide overhead = $804,000 (from above) A plantwide rate would be 804,000/90,000 = $8.93 per machine hour Using this would mean an inaccurate product cost, for example a product which had a high frabrication content would be undercharged overhead ($8.93 vs. $9.62) Case Study 10.3

Material Handling Costs = $20000 = Receipt of Materials Batch Setup Costs = $12000 = Production Batches Product Design = $30000 = Customer Orders Machining Costs = $45000 = Machine hours Service Support = $20000 = Service Visits Purchasing Dept = $28000 = Purchase Orders

Traditional Product Costs Window frames = $20+$30 + (4/16 x $155000)/2000 = $69.375 Doors = $35 + $40 + (7/16 x $155000)/3000 = $97.6 Cabinets = 25 + 50 + 5/16 x155000/1000 = 123.44 costs under ABC

Windows Doors Cabinets Total Materials H 3333.33 10000 6666.67 20000 Batch setup 3000 6000 3000 12000 Product Des 15000 5000 10000 30000 Machining 10000 15000 20000 45000 Service 10666.67 5333.33 4000 20000 Purchasing 5333.33 4000 18666.67 28000 47333.33 45333.33 62333.34 155000

New product costs: Windows frames = 20+30+47333.33/2000 = 73.67 Doors = 35+40+45333.33/3000 = 90.11 Cabinets = 25+50+62333.34/1000 = 137.33

**********MADE A MISTAKE WITH MACHINE HOURS!!**************