chapter

26(11)
Cost Allocation and Activity-Based Costing
______________________________________________
OPENING COMMENTS
Chapter 26(11) deals with the distortion that can occur in product costing if overhead is not applied properly. It presents three methods for allocating overhead: (1) a single plantwide factory overhead rate, (2) multiple production department factory overhead rates, and (3) activity-based costing (ABC). As you cover these methods, stress that they represent a trade-off between accuracy and complexity. While ABC provides a more accurate means to trace overhead costs to products, it is also more complex and more expensive to implement. However, with global competition squeezing the prices many businesses can charge for their products and services, an accurate product cost is becoming crucial. For many companies, the benefits of ABC far outweigh the costs of implementing this new system. After studying this chapter, your students should be able to: 1. 2. 3. 4. 5. 6. Identify three methods used for allocating factory overhead costs to products. Use a single plantwide factory overhead rate for product costing. Use multiple production department factory overhead rates for product costing. Use activity-based costing for product costing. Use activity-based costing to allocate selling and administrative expenses to products. Use activity-based costing in a service business.

STUDENT FAQS
Which of the three methods for allocating factory overhead cost to products is better? Why would someone choose the multiple production department FOH rate method when it is more complicated to calculate than the single plantwide rate? How is the selection of the allocation base for a production department made?

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How does the activity-based costing method differ from the single plantwide and the multiple production department FOH rate methods? In service departments, how would activity-based costing be used? Which of the three methods for allocating costs of products can lead to significant product cost distortions? Can activity-based costing be used in service businesses? If so, how? Why are selling and administrative expenses often allocated by an activity-based costing method rather than sales volume? How are activity-based rates determined? What is an activity base?

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For Chapter 26(11) 26(11) Cost Allocation and Activity-Based Costing 27(12) Cost Management for Just-inTime Environments

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IN-CLASS AND HOMEWORK ASSIGNMENT CHART

Number EO26(11)-1 EO26(11)-2 EO26(11)-3 Objective 26(11)-1 26(11)-2 26(11)-2 Description Difficulty Easy Easy Easy Time 5 min 5 min 5 min AACSB Analytic Analytic Analytic IMA Cost Management Cost Management Cost Management SS GL

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Number EO26(11)-4 EO26(11)-5 EO26(11)-6 EO26(11)-7 EO26(11)-8 EO26(11)-9 EO26(11)-10 EO26(11)-11 EO26(11)-12 EO26(11)-13 EO26(11)-14 EO26(11)-15 EO26(11)-16 PE26(11)-1A PE26(11)-1B

Objective 26(11)-3 26(11)-3 26(11)-3 26(11)-3 26(11)-3 26(11)-3 26(11)-4 26(11)-5 26(11)-4 26(11)-4 26(11)-5 26(11)-6 26(11)-6 26(11)-2 26(11)-2

Description

Difficulty Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy

Time 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 5 min 10 min 10 min

AACSB Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic

Single plant wide overhead rate Single plant wide overhead rate Multiple production department factory overhead rates Multiple production department factory overhead rates Activity-based costing: factory overhead costs Activity-based costing: factory overhead costs Activity-based costingselling and administrative expenses Activity-based costingselling and administrative expenses Activity- based costing: service business Activity- based costing: service business Single plantwide overhead rate Single plantwide overhead rate Single plantwide overhead rate Product costs and product profitability

Easy Easy

IMA Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management

SS

GL

PE26(11)-2A

26(11)-3

Easy

10 min

Analytic

PE26(11)-2B

26(11)-3

Easy

10 min

Analytic

PE26(11)-3A PE26(11)-3B PE26(11)-4A

26(11)-4 26(11)-4 26(11)-5

Easy Easy Easy

10 min 10 min 10 min

Analytic Analytic Analytic

PE26(11)-4B

26(11)-5

Easy

10 min

Analytic

PE26(11)-5A PE26(11)-5B Ex26(11)-1 Ex26(11)-2 Ex26(11)-3 Ex26(11)-4

26(11)-6 26(11)-6 26(11)-2 26(11)-2 26(11)-2 26(11)-2

Easy Easy Easy Easy Easy Moderate

10 min 10 min 10 min 15 min 15 min 30 min

Analytic Analytic Analytic Analytic Analytic Analytic

Exl

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Number

Objective

Ex26(11)-5

26(11)-3

Ex26(11)-6

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

Ex26(11)-7

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

Ex26(11)-8

26(11)-4

Ex26(11)-9 Ex26(11)-10 Ex26(11)-11

26(11)-4 26(11)-4 26(11)-4

Description reports, using s single plant wide factory overhead rate Multiple production department factory overhead rate method Single plant wide and multiple production department factory overhead rate methods and product cost distortion Single plant wide and multiple production department factory overhead rate methods and product cost distortion Identifying activity bases in an activitybased cost system Product costs using activity rates Product costs using activity rates Activity rates and product costs using activity-based costing

Difficulty

Time

AACSB

IMA

SS

GL

Easy

20 min

Analytic

Cost Management Cost Management

Exl

Easy

20 min

Analytic

Moderate

30 min

Analytic

Cost Management

Easy

10 min

Analytic

Cost Management Cost Management Cost Management Cost Management

Easy Easy Easy

15 min 15 min 20 min

Analytic Analytic Analytic

Exl Exl

Ex26(11)-12

26(11)-4

Ex26(11)-13

26(11)-2, 26(11)-4 26(11)-3

Ex26(11)-14

Ex26(11)-15

26(11)-4

Ex26(11)-16

26(11)-2, 26(11)-4 26(11)-5

Ex26(11)-17

Ex26(11)-18

26(11)-5

Ex26(11)-19

26(11)-6

Ex26(11)-20

26(11)-6

Activity cost pools, activity rates, and product costs using activity-based costing Activity-based costing and product cost distortion Multiple production department factory overhead rate method Activity-based costing and product cost distortion Single plant wide rate and activity-based costing Evaluating selling and administrative cost allocations Construct and interpret a product profitability report, allocating selling and administrative expenses Activity-based costing and customer profitability Activity-based costing

Easy

20 min

Analytic

Cost Management

Exl

Moderate

30 min

Analytic

Cost Management Cost Management Cost Management Cost Management Cost Management Cost Management

Exl

Easy

15 min

Analytic

Exl

Easy

15 min

Analytic

Exl

Moderate

30 min

Analytic

Exl

Moderate

30 min

Analytic

Moderate

30 min

Analytic

Moderate

30 min

Analytic

Cost Management Cost Exl

Moderate

30 min

Analytic

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Number Ex26(11)-21 Pr26(11)-1A Pr26(11)-2A

Objective 26(11)-5, 26(11)-6 26(11)-2 26(11)-3

Pr26(11)-3A

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

Pr26(11)-4A Pr26(11)-5A

26(11)-4 26(11)-5

Pr26(11)-6A

26(11)-6

Pr26(11)-1B Pr26(11)-2B

26(11)-2 26(11)-3

Pr26(11)-3B

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

Description for a hospital Activity-base costing an insurance company Single plantwide factory overhead rate Multiple production department factory overhead rates Activity-based and department rate product costing and product cost distortions Activity-based product costing Allocating selling and administrative expenses using activity-based costing Product costing and decision analysis for a passenger airline Single plantwide factory overhead rate Multiple production department factory overhead rates Activity-based and department rate product costing and product cost distortions Activity-based product costing Allocating selling and administrative expenses using activity-based costing Product costing and decision analysis for a hospital Ethics and professional conduct in business Identifying product cost distortion Activity-based costing Using a product profitability report to guide strategic decisions Product cost distortion Allocating bank administrative costs

Difficulty Moderate Moderate Moderate

Time 30 min 45 min 45 min

AACSB Analytic Analytic Analytic

IMA Management Cost Management Cost Management Cost Management Cost Management

SS Exl

GL

Difficult

1 3/4 hr

Analytic

Exl

Moderate Difficult

1 hr 1 3/4 hr

Analytic Analytic

Cost Management Cost Management

Exl Exl

Moderate

1 hr

Analytic

Cost Management Cost Management Cost Management Cost Management

Exl

Moderate Moderate

45 min 45 min

Analytic Analytic

Difficult

1 3/4 hr

Analytic

Exl

Pr26(11)-4B Pr26(11)-5B

26(11)-4 26(11)-5

Moderate Difficult

1 hr 1 3/4 hr

Analytic Analytic

Cost Management Cost Management

Exl Exl

Pr26(11)-6B

26(11)-6

Moderate

1 hr

Analytic

Cost Management Ethical Considerations Cost Management Cost Management Cost Management Cost Management Cost Management

Exl

SA26(11)-1 SA26(11)-2 SA26(11)-3 SA26(11)-4

26(11)-5 26(11)-2 26(11)-4 26(11)-2

Moderate Moderate Moderate Moderate

15 min 15 min 20 min 45 min

Ethics Analytic Analytic Analytic

SA26(11)-5 SA26(11)-6

26(11)-3 26(11)-5

Moderate Moderate

30 min 30 min

Analytic Analytic

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

KEY TERMS
Product Costing

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

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

KEY TERMS
Single Plantwide Factory Overhead Rate Method

SUGGESTED APPROACH
In this objective, the text reviews the method for allocating overhead that was used in Chapter 17(2) under job order costing. The single plantwide overhead rate is calculated as follows: Single Plantwide Factory Overhead Rate = Total Budgeted Factory Overhead Costs Total Budgeted Allocation Base

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

GROUP LEARNING ACTIVITYPlantwide Overhead Rate

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

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

KEY TERMS
Multiple Production Department Factory Overhead Rate Method Production Department Factory Overhead Rates

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

DEMONSTRATION PROBLEMMultiple Production Department Factory Overhead Rates

TM 26(11)-2 presented information for Franklin Manufacturing. Use this TM as a basis for illustrating the multiple production department rate method. Franklin Manufacturing had traced its factory overhead costs to the companys two production departments. These costs are: Production Dept. #1$160,000 Production Dept. #2$340,000 You may want to point out that, although the text does not show an example where plantwide overhead costs are allocated to production departments, this is a necessary step for most companies using departmental overhead rates. This additional complexity is omitted from the chapter in order to simplify the discussion. Once the overhead costs have been assigned to each production department, the company must choose the basis for allocating overhead to products. Assume that overhead costs will be allocated based on direct labor hours in Dept. #1 (a labor-intensive department) and machine hours in Dept. #2 (a more automated department). Budgeted direct labor and machine hours for these departments are: Production Dept. #112,000 direct labor hours Production Dept. #210,000 machine hours The departmental overhead rates would be calculated as follows: Production Dept. #1:
$160, 000 $13.33 per direct labor hour 12, 000

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Production Dept. #2:

$340, 000 $34.00 per machine hour 10, 000

On TM 26(11)-2, your students were asked to calculate the overhead allocated to a product using a single plantwide factory overhead rate. Now, instruct your students to calculate the overhead allocated to that same product using departmental overhead rates, assuming the product used 2 direct labor hours in Dept. #1 and 4 machine hours in Dept. #2. Overhead Allocated in Dept. #1: 2 direct labor hours $13.33/hr. = $ 26.66 Overhead Allocated in Dept. #2: 4 machine hours $34.00/hr. = 136.00 Total $162.66 Ask your students to comment on the differences in overhead allocated to Franklin s product using the single plantwide rate and multiple department rates. With the single plantwide rate, all overhead is allocated based on direct labor hours even though the overhead costs in Dept. #2 are machinery related. By allocating Dept. #2 costs based on machine hours, the products that use the most machine time will be allocated the most overhead, which is rational for a highly automated department. The single rate averages all factory overhead costs together, rather than reflecting the departmental resources consumed.

OBJECTIVE 4
Use activity-based costing for product costing.

KEY TERMS
Activity Base Activity Cost Pools Activity Rate Activity-Based Costing (ABC) Method Engineering Change Order (ECO) Setup

SUGGESTED APPROACH
TM 26(11)-4 illustrates the allocation of overhead in an ABC system. In an ABC system, management must identify all the activities necessary to manufacture a product. Overhead costs are then allocated to these activities, forming activity cost pools. For example, one activity that absorbs overhead costs is machine setup. Under ABC, all costs incurred in setting up machines would be allocated to the setup activity cost pool. The goal of ABC is to allocate overhead to products based on the activities they consume in the manufacturing process. After defining an activity cost pool, an activity base is selected to link the overhead costs to the product. Continuing with the machine setup example, the total setup cost pool could be linked to products based on the number of times they require machines to be set up for production.

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The illustration in TM 26(11)-4 assumes a simple manufacturing process with only three activities. Therefore, there are only three activity cost pools from which to allocate costs to the five products produced. While discussing ABC, stress the following points: 1. 2. ABC changes only the way overhead costs are allocated. Direct materials and direct labor costs are still traced to products. When identifying the activities needed to manufacture their product, many companies find inefficiencies that they didnt know existed. These inefficiencies can be eliminated, reducing the products cost. ABC gained popularity because many manufacturing experts believed that traditional cost accounting undercosted complex products. Assigning too little cost to a product overstates its profit margin. Many companies developed ABC systems independently of their cost accounting systems. In such cases, ABC is used only for decision making. It is not used for inventory valuation or decision making.

3.

4.

LECTURE AIDThe Need for Activity Based Costing

The following real-world example illustrates how traditional cost systems can understate the cost of complex products. A manufacturer of surgical gloves traditionally made gloves in one color: white. The company received a request from one of its customers to make each size glove a different color. The customer wanted small gloves to be pink, medium to be yellow, and large to be green. Every time the manufacturer would start to produce a colored glove, the machines would have to be shut down while colored dye was pumped into them. At the end of the production run, workers had to clean the machines to remove the remaining dye. The special setup and cleaning caused the company to spend more on labor to make the colored gloves. No matter how thoroughly the machines were cleaned after producing a colored glove, they still contained residue from the dye. To remove the residue, materials had to be run through the machine. So a batch of gloves was made and scrapped just to prepare the machine to make white (or another color) gloves. The company allocated overhead based on machine hours. Since the white and colored gloves used exactly the same machine time while they were being made, they were assigned the same amount of overhead. As a result, the colored gloves were undercosted because they were clearly more expensive to produce. Another example (used by Cooper and Kaplan) is two pen factories one that sells only blue pens and one that sells pens of all colors. Both sell 100,000 pens per month. Assume you walk into the multicolor pen factory, but youre colorblind. How would you know you are in the factory that makes a variety of

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pen colors? Answer: There would be more activities than in the blue pen factory, such as color cleanouts, additional materials requisitions and purchasing, more quality checks and rework, etc.

DEMONSTRATION PROBLEMActivity Based Costing

Allocating overhead to products under an ABC system can be explained as a four-step process. Step 1: Identify activities. ABC costing allocates overhead to the activities that consume overhead costs. This forces a company to identify the activities necessary to make its product. For example, assume that a manufacturing company identifies the following activities as necessary to make a product: 1. Order materials. 2. Receive and inspect materials. 3. Schedule production. 4. Set up machines to make the product. 5. Make the product. 6. Inspect the finished product. 7. Pack and ship the product to the customer. Step 2: Allocate costs of the activities into activity cost pools. The company would start this step by determining the overhead costs it incurs to order materials (the first activity). Assume that these costs total $80,000 and include such items as the salaries of the purchasing agent(s) and staff, supplies used by the purchasing department, and depreciation on office equipment used by the purchasing department. Step 3: Select an activity base. A means to allocate the cost of each activity to the product must be chosen. This is known as selecting an activity base (also called an activity driver). The activity base for any activity should be the event that causes costs to be incurred. For example, placing an order causes purchasing costs to be incurred. Step 4: Calculate an activity rate and allocate costs to products. Assume that the purchasing department places 10,000 orders per year. The cost to place an order is calculated as follows:
Activity Rate Activity Cost Pool Activity Base

Activity Rate: Cost to place an order

$80,000 10,000 orders

$8 per order

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

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Once this process is complete for the purchasing activity, the same steps must be taken for the remaining activities. As a result, ABC is usually implemented only with the use of a computer programmed to do the many calculations required. Problem 26(11)-3A or 26(11)-3B (depending on homework assignment) can be used to demonstrate ABC further if desired.

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

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

GROUP LEARNING ACTIVITYABC Applied to Selling and Administrative Costs

Exhibit 11 in the text lists the selling and administrative activities for two products, Ipso and Facto. These products consume dramatically different amounts of selling and administrative attention. TM 26(11)-5 presents hypothetical dollar amounts for each of those activities. Divide your class into small groups and ask each group to discuss possible activity bases that could be used to allocate each cost. You may want to help your students start this project by suggesting possible activity bases for the first and/or second activity. Activity Post-Sale Technical Support Possible Activity Base Hours Spent Training Customers Number of Training Sessions Provided to Customers Time Spent Assisting Customers on a 1-800 Technical Support Hotline Hours Spent Writing Up Customer Orders Number of Technical Drawings Accompanying Orders Number of Pages in the Customer Orders

Order Writing

Encourage your students to come up with more than one possible activity base for each activity. After the groups have formulated their responses, ask them to share their ideas with the class. Next, tell your students that Abacus Company (the retailer for Ipso and Facto) has selected the activity bases listed on TM 26(11)-6 for allocating cost. Instruct your students to use this information to

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determine the activity rates for Abacus and the costs that should be allocated to Ipso and Facto. The solution is presented on TM 26(11)-7.

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

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

WRITING EXERCISEABC in a Service Business

In Exhibit 12, the text divides the operations of a hospital into five activities and assigns a cost to each of these activities. As a result, each customer is assigned only the costs of the hospital services (activities) he or she uses. Ask your students to select another type of service business and list the activities that business would perform in providing its services to customers. Next, ask your students to write a memo to the owner of that business explaining how activity-based costing could assist him/her with managing the business.