21-1
Chapter
21
Cost Allocation
and Performance
Measurement
Modified from Publisher Provided Slides
McGraw-Hill/Irwin
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21-2
Overhead Cost Allocation Methods
One of the most
difficult tasks in
computing accurate
unit costs lies in
determining the
proper amount of
overhead cost to
assign to each job.
McGraw-Hill/Irwin
Assigning
overhead is
difficult.
I agree!
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21-3
Activity-Based Cost Allocation
Activity Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Overhead Allocation
McGraw-Hill/Irwin
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Activity-Based Cost Allocation
A
B C
McGraw-Hill/Irwin
In the ABC method,
we recognize that many
activities within a
department drive
overhead costs.
© The McGraw-Hill Companies, Inc., 2005
21-5
Activity-Based Costing
Identify activities and assign indirect costs to
those activities.
Central idea . . .
• Products require activities.
• Activities consume resources.
McGraw-Hill/Irwin
A
B C
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21-6
Activity-Based Costing Benefits
 More detailed measures of costs.
 Better understanding of activities.
 More accurate product costs for . . .
• Pricing decisions.
• Product elimination decisions.
• Managing activities that cause costs.
 Benefits should always be compared
to costs of implementation.
McGraw-Hill/Irwin
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21-7
Identifying Cost Drivers
Most cost drivers are related to either volume or
complexity of production.
• Examples: machine time, machine setups,
purchase orders, production orders.
Three factors are considered in choosing a cost
driver:
• Causal relationship.
• Benefits received.
• Reasonableness.
McGraw-Hill/Irwin
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Activity-Based Costing Procedures
 Identify activities that consume resources.
 Assign costs to a cost pool for each activity.
 Identify cost drivers associated with each activity.
 Compute overhead rate for each cost pool:
Estimated overhead costs in activity cost pool
Rate =
Estimated number of activity units
 Assign costs to products:
Overhead
×
Rate
McGraw-Hill/Irwin
Actual
Activity
© The McGraw-Hill Companies, Inc., 2005
21-9
Activity-Based Costing
Let’s look at an
example comparing
traditional costing
with ABC.
We will start with
traditional costing.
McGraw-Hill/Irwin
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Traditional Costing vs. ABC
Example
Pear Company manufactures a product in regular
and deluxe models. Overhead is assigned on the
basis of direct labor hours. Budgeted overhead for
the current year is $2,000,000. Other information:
First, determine the unit cost of each model using
traditional costing methods.
McGraw-Hill/Irwin
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21-11
Traditional Costing
Overhead = Estimated overhead costs
Rate
Estimated activity
Overhead = $2,000,000 = $50 per DLH
Rate
40,000 DLH
McGraw-Hill/Irwin
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21-12
Traditional Costing
ABC will have different
overhead per unit.
Direct Material
Direct Labor
Manufacturing Overhead
$50 per hour × 1.6 hours
$50 per hour × 0.8 hours
Total Unit Cost
McGraw-Hill/Irwin
Deluxe
Model
$ 150
16
Regular
Model
$ 112
8
80
$
246
$
40
160
© The McGraw-Hill Companies, Inc., 2005
21-13
Activity-Based Costing
Pear Company plans to adopt activity-based
costing. Using the following activity center
data, determine the unit cost of the two
products using activity-based costing.
McGraw-Hill/Irwin
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21-14
Activity-Based Costing
Activity
Center
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
Cost
Driver
Orders
Orders
Tests
Hours
Overhead
Cost for
Activity
$
84,000
216,000
450,000
1,250,000
$ 2,000,000
Units
of
Activity
1,200
900
15,000
50,000
Rate
400 deluxe + 800 regular = 1,200 total
McGraw-Hill/Irwin
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21-15
Activity-Based Costing
Activity
Center
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
Cost
Driver
Orders
Orders
Tests
Hours
Overhead
Cost for
Activity
$
84,000
216,000
450,000
1,250,000
$ 2,000,000
Units
of
Activity
1,200
900
15,000
50,000
Rate
$ 70 per order
$240 per order
$ 30 per test
$ 25 per hour
Rate = Overhead Cost for Activity ÷ Units of Activity
McGraw-Hill/Irwin
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21-16
Activity-Based Costing
McGraw-Hill/Irwin
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21-17
Activity-Based Costing
McGraw-Hill/Irwin
Let’s complete
the table.
© The McGraw-Hill Companies, Inc., 2005
21-18
Activity-Based Costing
McGraw-Hill/Irwin
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21-19
Activity-Based Costing
Total overhead = $720,000 + $1,280,000 = $2,000,000
Recall that $2,000,000 was the original amount of
overhead assigned to the products using traditional
overhead costing.
McGraw-Hill/Irwin
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21-20
Activity-Based Costing
McGraw-Hill/Irwin
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21-21
Traditional Costing vs. ABC
Traditional Costing
Deluxe
Regular
Model
Model
Direct labor
$
150
$
112
Direct material
16
8
Overhead
80
40
Total cost
$
246
$
160
ABC
Deluxe
Regular
Model
Model
$
150
$
112
16
8
144
32
$
310
$
152
This result is not uncommon when activity-based costing
is used. Many companies have found that low-volume,
specialized products have greater overhead costs than
previously realized.
McGraw-Hill/Irwin
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21-22
Costs and Cost Drivers in
Activity-Based Costing
Cost
Materials purchasing
Materials handling
Personnel processing
Equipment depreciation
Quality inspection
Indirect labor for
equipment setups
Engineering costs for
product modifications
McGraw-Hill/Irwin
Exh.
21-6
Cost Driver
Number of purchase orders
Number of materials
requisitions
Number of employees hired
or laid off
Number of products
produced or hours of use
Number of units inspected
Number of setups required
Number of modifications
© The McGraw-Hill Companies, Inc., 2005
21-23
Departmental Expense Allocation
Direct expenses are
incurred for the sole
benefit of a specific
department.
Indirect expenses
benefit more than one
department and are
allocated among
departments benefited.
McGraw-Hill/Irwin
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Illustration of Indirect
Expense Allocation
Exh.
21-7
Classic Jewelry pays its janitorial service $300
per month to clean its store. Management
allocates this cost to its three departments
according to the floor space each occupies.
McGraw-Hill/Irwin
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21-25
Illustration of Indirect
Expense Allocation
Exh.
21-7
Classic Jewelry pays its janitorial service $300
per month to clean its store. Management
allocates this cost to its three departments
according to the floor space each occupies.
McGraw-Hill/Irwin
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21-26
Illustration of Indirect
Expense Allocation
Exh.
21-7
Classic Jewelry pays its janitorial service $300
per month to clean its store. Management
allocates this cost to its three departments
according to the floor space each occupies.
McGraw-Hill/Irwin
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21-27
Bases for Allocating
Service Department Costs
Exh.
21-8
Service department costs are shared, indirect
expenses that support the activities of two or
more production departments.
McGraw-Hill/Irwin
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21-28
Service Department Costs
Question
ABCO allocates its $300,000 personnel cost to
operating departments based on the number of
employees in each department. The assembly
department has 100 employees and the
packing department has 150 employees. What
amount of cost is allocated to assembly?
a. $100,000
b. $120,000
c. $150,000
d. $180,000
McGraw-Hill/Irwin
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21-29
Service Department Costs
Question
ABCO allocates its $300,000 personnel cost to
operating departments based on the number of
employees in each department. The assembly
department has 100 employees and the
packing department has 150 employees. What
amount of cost is allocated to assembly?
a. $100,000
Assembly percentage
b. $120,000
= 100 ÷ (100 + 150) = 40%
c. $150,000
40% of $300,000 = $120,000
d. $180,000
McGraw-Hill/Irwin
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21-30
Preparing Departmental
Income Statements
Let’s prepare departmental income statements
using the following steps:
 Direct expense accumulation.
 Indirect expense allocation.
 Service department expense allocation.
McGraw-Hill/Irwin
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21-31
Step 1: Direct Expense Accumulation
Direct expenses are traced to each
department without allocation.
Service
Dept. One
Operating
Dept. One
McGraw-Hill/Irwin
Service
Dept. Two
Operating
Dept. Two
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21-32
Step 2: Indirect Expense Allocation
Indirect expenses are allocated to all departments
using appropriate allocation bases.
Allocation
Operating
Dept. One
McGraw-Hill/Irwin
Allocation
Allocation
Service
Dept. One
Service
Dept. Two
Allocation
Operating
Dept. Two
© The McGraw-Hill Companies, Inc., 2005
21-33
Step 3: Service Department
Expense Allocation
Service department total expenses (original direct
expenses + allocated indirect expenses) are
allocated to operating departments.
Operating
Dept. One
McGraw-Hill/Irwin
Service
Dept. One
Service
Dept. Two
Allocation
Allocation
Operating
Dept. Two
© The McGraw-Hill Companies, Inc., 2005
21-34
Departmental Expense
Allocation Spreadsheet
Let’s examine this three-step
allocation procedure for
Owl Company.
McGraw-Hill/Irwin
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21-35
Departmental Expense
Allocation Spreadsheet
Allocation
Base
Direct expenses
Salaries
Supplies
Expense Allocation to Departments
Sales
Service Service Sales
Dept.
Dept.
Dept.
Dept.
Total
Two
One
Two
Expense One
$ 20,000 $ 1,000 $ 2,000 $ 6,000 $ 11,000
Payroll
700
400
300
100
1,500
Requisitions
Step 1: Direct expenses are traced to service departments
and sales departments without allocation.
McGraw-Hill/Irwin
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21-36
Departmental Expense
Allocation Spreadsheet
Of a total of 2,000 square feet, the
service
departments
to Departments
Allocation
Expense
occupy 200 square feet each, sales
Sales
Service Sales one
Service department
Dept.
Dept. two
Dept.
Dept. department
Total
Allocationfeet,
occupies 600 square
and sales
Two
One
Two
Expense One
Base
occupies
1,000
square
feet.
Direct expenses
Salaries
Supplies
Indirect expenses
Rent
Utilities
Total dept. expenses
$ 20,000 $ 1,000 $ 2,000 $ 6,000 $ 11,000
Payroll
700
400
300
100
1,500
Requisitions
Floor space
Floor space
5,000
3,000
1,000
1,000
10,000
500
300
100
100
1,000
$ 32,500 $ 2,200 $ 3,400 $ 9,700 $ 17,200
Step 2: Indirect expenses are allocated to both the service
and the sales departments based on floor space occupied.
McGraw-Hill/Irwin
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21-37
Departmental Expense
Allocation Spreadsheet
Step 3: Service department total expenses (original direct
Expense Allocation to Departments
expenses + allocated indirect expenses)
are allocated
to
Service Service
Sales
Sales
sales departments.
Allocation
Total
Dept.
Dept.
Dept.
Dept.
Base
Expense
One
Two
One
Two
Direct expenses
Salaries
Payroll
$ 20,000 $ 1,000 $ 2,000 $ 6,000 $ 11,000
Sales department
one has1,500
$40,000100in sales
sales 700
Supplies
Requisitions
300 and
400
Indirect expenses
department two has $48,000 in sales.
Rent
Floor space
10,000
1,000
1,000
3,000
5,000
Utilities
Floor space
1,000
100
100
300
500
Total dept. expenses
$ 32,500 $ 2,200 $ 3,400 $ 9,700 $ 17,200
Service dept. expenses
Service Dept. One
Sales
(2,200)
1,000
1,200
Service Dept. Two Employees
Total expenses
$ 32,500 $ 0
$ 3,400 $ 10,700 $ 18,400
McGraw-Hill/Irwin
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21-38
Departmental Expense
Allocation Spreadsheet
Step 3: Service department total expenses (original direct
Expense Allocation to Departments
expenses + allocated indirect expenses)
are allocated
to
Sales
Sales
Service Service
sales departments.
Dept.
Dept.
Dept.
Dept.
Total
Allocation
Base
Expense
One
Two
One
Two
Direct expenses
$ 20,000 $ 1,000 $ 2,000 $ 6,000 $ 11,000
Payroll
Salaries
Sales department
one has
28 employees
sales 700
300 and 400
100
1,500
Requisitions
Supplies
Indirect expensesdepartment two has 40 employees.
5,000
3,000
1,000
1,000
10,000
Floor space
Rent
500
300
100
100
1,000
Floor space
Utilities
$ 32,500 $ 2,200 $ 3,400 $ 9,700 $ 17,200
Total dept. expenses
Service dept. expenses
1,200
1,000
(2,200)
Sales
Service Dept. One
2,000
1,400
(3,400)
Service Dept. Two Employees
$ 12,100 $ 20,400
$ 0
$ 32,500 $ 0
Total expenses
McGraw-Hill/Irwin
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21-39
Departmental Expense
Allocation Spreadsheet
Allocation
Base
Direct expenses
Salaries
Supplies
Indirect expenses
Rent
Utilities
Total dept. expenses
Service dept. expenses
Service Dept. One
Service Dept. Two
Total expenses
McGraw-Hill/Irwin
Expense Allocation to Departments
Sales
Service Service Sales
Dept.
Dept.
Dept.
Dept.
Total
Two
One
Two
Expense One
$ 20,000 $ 1,000 $ 2,000 $ 6,000 $ 11,000
Payroll
700
400
300
100
1,500
Requisitions
Floor space
Floor space
Sales
Employees
5,000
3,000
1,000
1,000
10,000
500
300
100
100
1,000
$ 32,500 $ 2,200 $ 3,400 $ 9,700 $ 17,200
(2,200)
$ 32,500 $
0
1,200
1,000
2,000
1,400
(3,400)
$ 12,100 $ 20,400
$ 0
© The McGraw-Hill Companies, Inc., 2005
21-40
Departmental
Income Statements
Now that we have the costs,
let’s do an income statement.
McGraw-Hill/Irwin
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21-41
Departmental
Income Statements
Sales
Cost of goods sold
Gross profit on sales
Operating expenses
Salaries
Supplies
Rent
Utilities
McGraw-Hill/Irwin
Combined
$ 88,000
38,000
$ 50,000
Sales
Sales
Dept. One Dept. Two
$ 40,000 $ 48,000
20,000
18,000
$ 20,000 $ 30,000
$
$
17,000
1,100
8,000
800
6,000
400
3,000
300
$ 11,000
700
5,000
500
© The McGraw-Hill Companies, Inc., 2005
21-42
Departmental
Income Statements
Combined
$ 88,000
38,000
$ 50,000
Sales
Cost of goods sold
Gross profit on sales
Operating expenses
Salaries
$
Supplies
Rent
Utilities
Service Department One
Service Department Two
Total operating expenses
$
Net income
$
McGraw-Hill/Irwin
17,000
1,100
8,000
800
2,200
3,400
32,500
17,500
Sales
Sales
Dept. One Dept. Two
$ 40,000 $ 48,000
20,000
18,000
$ 20,000 $ 30,000
$
6,000
400
3,000
300
1,000
1,400
$ 12,100
$ 7,900
$ 11,000
700
5,000
500
1,200
2,000
$ 20,400
$
9,600
© The McGraw-Hill Companies, Inc., 2005
21-43
Departmental Contribution
to Overhead
Departmental revenue
– Direct expenses
= Departmental contribution
Departmental contribution . . .
• Is used to evaluate departmental performance.
• Is not a function of arbitrary allocations of indirect
expenses.
A department may be eliminated when its
departmental contribution is negative.
McGraw-Hill/Irwin
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21-44
Eliminating an
Unprofitable Department
As a general rule, a department can
be considered a candidate for
elimination if its revenues are less
than its escapable expenses.
• Direct expenses are usually
escapable.
• Indirect expenses are usually
inescapable.
McGraw-Hill/Irwin
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21-45
Departmental Contribution
to Overhead
Let’s recast Owl Company’s income
statement using the departmental
contribution approach where indirect
expenses are not allocated.
McGraw-Hill/Irwin
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21-46
Departmental Contribution
to Overhead
Net income for
the company is
still $17,500.
McGraw-Hill/Irwin
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21-47
Departmental Contribution
to Overhead
Departmental contributions
to indirect expenses
(overhead) are emphasized.
McGraw-Hill/Irwin
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21-48
Departmental Contribution
to Overhead
Departmental contributions are
positive so neither department
is a candidate for elimination.
McGraw-Hill/Irwin
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21-49
Controllable Costs
Costs are controllable
if the manager
has the power to
determine, or strongly
influence, the amounts
incurred.
I’m in
control
A manager’s
performance evaluation
should be based on
controllable costs.
McGraw-Hill/Irwin
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21-50
Distinguishing Controllable
and Direct Costs
Direct costs are traced to departments, but
may not be controllable by the department
manager.
• Example: Department managers usually
have no control over their own salaries.
Controllable costs are identified with a
particular manager and a definite time period.
• All costs are controllable at some level of management if
the time period is long enough.
McGraw-Hill/Irwin
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21-51
Responsibility Accounting
An accounting system that
provides information . . .
Relating to the
responsibilities of
individual managers.
McGraw-Hill/Irwin
To evaluate
managers on
controllable items.
© The McGraw-Hill Companies, Inc., 2005
21-52
Successful
implementation
of responsibility
Responsibility
Accounting
accounting may use organization charts with
clear lines of authority and clearly defined
levels of responsibility.
Board of Directors
President
Vice President
of Finance
Vice President
of Operations
Vice President
of Marketing
Store Manager
Department Manager
McGraw-Hill/Irwin
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21-53
Responsibility Accounting
Performance Reports
Amount of detail varies according
to level in organization.
A department manager
receives detailed reports.
McGraw-Hill/Irwin
A store manager receives
summarized information
from each department.
© The McGraw-Hill Companies, Inc., 2005
21-54
Responsibility Accounting
Performance Reports
Amount of detail varies according
to level in organization.
Management by exception:
Upper-level management
does not receive operating
detail unless problems arise.
The vice president of operations
receives summarized information
from each store.
McGraw-Hill/Irwin
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21-55
End of Chapter 21
McGraw-Hill/Irwin
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