Chapter 6 Cost Allocation and Activity

Chapter 6
Cost Allocation and Activity-Based Costing
1. Indirect costs are allocated to (1) provide information for decision making, (2) reduce
frivolous use of common resources, (3) encourage evaluation of internally provided
services, and (4) calculate the “full cost” of products for GAAP reporting.
2. The statement is false. Cost allocation refers to the process of assigning indirect costs.
Direct costs are traced to cost objects. Costs are allocated for a variety of reasons. It is not
economically feasible to directly trace some costs to cost objects—these costs are classified
as indirect costs and are allocated to the cost object via the use of an allocation base.
3. Charging for internal services can reduce frivolous use of resources and encourage
departments being charged to critically evaluate the service. In addition, GAAP requires
that all manufacturing costs be assigned to goods being produced. Thus, cost allocation of
indirect manufacturing costs is required.
4. Cost-plus contracts specify that the contractor will be paid for the cost of production (or
services) plus some fixed amount or percentage of cost. Defense contracts with the federal
government are often cost-plus contracts.
A major problem with cost-plus contracts is that they give the contractor an incentive to
allocate as much cost as possible to the cost-plus contract (via the choice of an allocation
base) where it will be reimbursed.
5. A cost objective is a product, service, or department that receives an allocation of cost. For
example, a production department that receives an allocation of janitorial cost is a cost
objective. Likewise, a product in a department that receives an allocation of depreciation of
equipment is a cost objective.
6. A cost pool is a collection of individual indirect costs whose total is allocated using one
allocation base. Cost pools are often formed along department lines. For example, the
maintenance cost pool would include all costs of the maintenance department.
7. A concern in forming a cost pool is that the costs within the cost pool be similar or
homogeneous. It is unlikely that variable and fixed costs are similar (i.e., that one
allocation base is suitable for allocating both fixed and variable costs). Homogeneous cost
pools provide more accurate information.
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8. Number of employees in a department would, most likely, result in a cause-and-effect
allocation (at least for the variable costs in the cafeteria).
9. (1) Benefits received (relative benefits)
(2) Ability to bear costs
(3) Equity or fairness
10. If budgeted costs are allocated, then service departments cannot pass on inefficiencies and
waste. Allocating actual costs gives the service department little incentive to be efficient.
11. In a responsibility accounting system, revenues and costs are traced to departments/
divisions and individuals with related responsibility for generating revenues and controlling
costs. This facilitates performance evaluation of managers and the operations under their
12. Sometimes managers are allocated costs beyond their control in order to make them aware
that the cost exist and must be covered by revenues of the firm.
13. Unitizing fixed costs make them appear to be variable. If the unitized fixed costs are then
allocated to divisions based on, for example, revenue, divisional managers may make
decisions in order to maximize divisional profits that are not in the company’s best interest.
This problem can be avoided by lump-sum allocations of fixed costs.
14. Traditional allocation methods use a small number of cost pools and allocation bases
related to production volume. However, some costly activities are not related to production
volume. Consider the costs associated with setups—in a traditional costing system setup
costs would be allocated based on production volume and high volume products will
receive most of the allocated cost even though low volume products may require an equal
number of setups.
15. The traditional costing approach typically uses allocation bases that are measures of
production volume (e.g., direct labor hours, direct labor cost, or machine hours). Also, few
cost pools are used under the traditional approach (e.g., one or two cost pools).
ABC focuses on major activities that cause overhead costs to be incurred. Many of these
activities are not related to production volume. Cost pools are formed for each major
activity and costs are assigned to products using an allocation base that is a cost driver.
Many of the cost drivers are not related to production volume. ABC typically uses more
cost pools and related cost drivers.
Chapter 6 Cost Allocation and Activity-Based Costing
16. ABC will tend to give more accurate costs than a traditional cost system when:
(1) the production process is complex and varied (high and low volume products),
(2) products consume resources differently, and
(3) there are activities that are not related to production volume (e.g., setups).
17. (1) ABC is more costly to develop and maintain than a traditional system.
(2) In practice, ABC is used to develop the full cost of products. The ABC cost per unit
does not measure the incremental costs needed to produce an item. Therefore, it is not
always useful for decision making.
18. ABC focuses on activities with the goal of measuring costs of products and services
produced by the firm. ABM focuses on activities with the goal of managing the activities
themselves. ABC has the goal of accurately computing costs of products and services while
ABM focuses on reducing the costs of or the demand for major activities.
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E1. Fixed costs (e.g., administrative costs) are sometimes allocated based on a
measure of business activity (e.g., sales). This makes the costs appear to be
variable (e.g., the higher sales, the higher the allocation of administrative
cost). In turn, this may lead to poor decisions if managers treat the allocated
costs as incremental.
E2. This allocation is potentially harmful. A hotel manager will tend to
overestimate the costs that increase with revenue. And this may lead to poor
decisions that affect revenue. For example, suppose a hotel manager is
considering a trade association’s request for a special convention rate of $70
per room during a slow season. The manager estimates that variable costs per
room are $75 including $10 of allocated costs for general administration. In
this case, the manager will turn down the request even though his or her
company would really make $5 of incremental profit per room. Remember,
$10 of allocated costs appear variable but, in fact, are fixed. Thus, actual
incremental costs are only $65, which is $5 less than incremental revenue of
E3. According to Table 1 displayed at this Web site, building depreciation is
allocated based on square footage, telecommunications costs are allocated
based on number of phone numbers (referred to as direct telephone ID), and
administrative and general costs are allocated based on a unit’s total expense
as a percent of the total expense of all units.
These allocations are not “cause and effect” allocations. Consider building
depreciation. When a unit occupies space, it doesn’t cause cost equal to
allocated depreciation. It may be that the space wasn’t occupied, in which
case no cost was caused. Or, occupancy may have led to a need to rent
additional space, causing a cost much higher than allocated depreciation.
Rather, the allocations are based on “relative benefit.” Thus, for example, if
you occupied space you benefited! And the assumption is that your benefit
was proportionate to space occupied.
E4. Star might want to encourage department managers to evaluate security
services. When security costs are allocated, departments have an incentive to
Chapter 6 Cost Allocation and Activity-Based Costing
voice concerns about the cost of security service. This may make the security
department more efficient. In addition, allocation of security costs that relate
to manufacturing are required under GAAP.
E5. a. Service Department
Human resources
Graphic design
Food services
Allocation Base
Number of employees
Number of pages copied
Floor space
Number of sales transactions
Time spent on design work
Number of employees
b. Under the direct method costs are not allocated between service
departments. Thus, the Human Resource department would not receive a
share of Food Services costs.
E6. Total fixed costs to be allocated = $60,000 + 15,000 + 15,000 + 2,000 =
Fixed costs allocated to Sales ($92,000 × .3)
Variable costs allocated to Sales (1,500,000 copies × $.02)
Total costs allocated to Sales
$ 27,600
$ 57,600
Fixed costs allocated to Admin. ($92,000 × .7)
Variable costs allocated to Admin (2,500,000 copies × $.02)
Total costs allocated to Sales
$ 64,400
E7. Allocation Base
Prod. Dept.1
Prod. Dept.2
Square footage
Direct labor hrs.
(1) As indicated, the choice of the allocation base greatly affects the
allocations of cost. Use of square footage as the allocation base assigns 60%
of the cost to department 2 and 40% to department 1. However, use of direct
labor hours allocates 60% of the cost to department 1 and only 40% to
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department 2. Department 1 would prefer to be allocated cost based on square
footage and department 2 would prefer direct labor hours as the base.
(2) An allocation base that results in a cause and effect allocation is preferred.
If maintenance costs are mostly related to building maintenance, then square
footage is more likely to result in a cause and effect allocation. However, if
maintenance costs are mostly made up of machine maintenance, then machine
hours might be a better allocation base.
E8. P1 has 150/375 = 40% of production department employees.
P2 has 225/375 = 60% of production department employees.
Total cost
Service dept.
Cost Allocated to
E9. a. The manufacturing overhead allocation includes $52 of fixed cost which
will not increase if the special order is accepted (i.e., it is not an
incremental cost). The incremental revenue and incremental costs
associated with the order suggests that the company will be better off by
$45,000 if the order is accepted.
Incremental revenue (1,000 × $175)
Incremental costs
Material (1,000 × $80)
Labor (1,000 × $40)
Variable overhead (($1,000 × $10)
Incremental profit
$ 45,000
b. Managers who focus on reported cost may (incorrectly) treat the $52 of
fixed cost as an incremental cost. In this case they will (incorrectly)
conclude that the order should not be accepted because the total cost
($182) is greater than the offer ($175).
Chapter 6 Cost Allocation and Activity-Based Costing
E10. a. The reason that allocated general and administrative costs are higher for
the Services Department is that revenue in the Sales Department has
decreased. Since general and administrative costs are allocated based on
actual revenues, changes in one department’s revenue affects another
department’s allocation of overhead costs (since it has a higher
proportion of total revenue).
b. If accounting department costs are affected by Rex Kerr’s decisions, then
he should be held responsible for those costs. However, it appears that
his department is being allocated costs over which he has no control.
Allocating cost beyond Kerr’s control may cause him to feel that he has
been treated unfairly, especially if his performance is based on the
service department’s profits.
E11. a. The manager of Keller Auto Insurance will perceive that allocated service
department costs are variable cost (when auto insurance revenue
increases, the allocated costs increase).
b. In performing incremental analysis, the president of Keller Auto
Insurance will tend to overestimate incremental costs because he or she
will treat allocated costs as incremental costs (when some of the costs
are, in all likelihood, fixed).
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The use of a single cost pool causes A1 to be undercosted and B1 to be
overcosted. With a single cost pool, both products receive the same
allocation of cost per labor hour. However, A1 uses relatively more time
in P1 where overhead costs are high while B1 uses relatively more time
in P2 where overhead costs are low.
The one-cost pool overhead rate is:
$3,000,000 ÷ 400,000 DLH = $7.50 /DLH
Each product requires 5 direct labor hours in total. Therefore, each will be
allocated $37.50 in overhead costs ($7.50 × 5)
Now let’s calculate the amount of overhead allocated to each product if Mott
used a separate overhead cost pool for each production department.
P1’s overhead rate will be $2,000,000 ÷ 100,000 DLH = $20.00 per direct
labor hour.
P2’s overhead rate will be $1,000,000 ÷ 300,000 DLH = $3.33 per direct
labor hour.
Overhead allocated to each unit of A1 will be:
(2 labor hours × $20) + (3 labor hours × $3.33)
Overhead allocated to each unit of B1 will be:
(1 labor hour × $20) + (4 labor hours × $3.33)
Note that the overhead allocated to B1 is lower with two cost pools while the
allocation to A1 is higher.
E13. a. If the costs of the design department are fixed and the department is able
to complete jobs on a timely basis, then the opportunity cost of using the
department is approximately zero and equal to the allocation (which is
also zero).
b. Subsidiaries often have to go outside for design work because of time
delays. Thus, there is an opportunity cost associated with use that is
greater than the allocation (which is zero).
c. The allocation of $50 per hour must be less than the opportunity cost
(subsidiaries are willing to pay $70 per hour to avoid delays). Thus, they
must have a benefit that exceeds $70.
Chapter 6 Cost Allocation and Activity-Based Costing
d. The opportunity cost of using design services may be less than $50 since
no one is being turned away or delayed. Thus, there does not appear to be
a benefit foregone because of use.
Inspection of raw materials
Production equipment repairs and maintenance
Raw materials storage
Plant heat, light, water, and power
Finished product quality control
Production line setups
Number of receipts
Machine hours
Dollar value of raw materials
Square footage
Number of inspections
Number of setups
E15. Cost per setup = $1,500,000 ÷ 1,000 = $1,500
Cost of setups related to EP150 = 2 × $1,500 = $3,000
Setup cost per unit of EP150 = $3,000 ÷ 750 = $4
E16. If the cost to process an order is much higher at one plant than at the other
and the orders are similar, then there is a good chance that the costs are out
of control at the higher cost location and a manager should investigate the
situation. Conceivably, the company can adopt “best practices” from the
low cost plant.
E17. a. The cost of filling orders at is:
($250,000 + $300,000) ÷ 100,000 = $5.50 per order.
The cost of filling orders at the auto supply chain is only $4 per hour.
While this is lower, it may be that that, due to its size, the auto supply
chain has a “state of the art” warehouse. It may be unrealistic for, which is relatively small, to compare itself to such a
large company.
b. Possibly, order “pickers” can take multiple order sheets out to the
warehouse when individual orders are small. This will save considerable
time going back and forth to the warehouse and may lead to lower costs
if the company is willing to fire or reassign one or more of the five
workers who pick parts.
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P1. a.
Employee benefits
Amount allocated
Allocation Base
Head count
Amount allocated
Square feet
Amount allocated
General and adm. costs
Amount allocated
$ 1,333,334
$ 2,683,334
$ 666,666
Profit Report: (using multiple cost pools/allocation bases)
Less direct costs
Less allocated costs
Income before taxes
$ 2,316,666
$ 683,334
Using multiple cost pools and multiple allocation bases allocates $316,666
more overhead cost to consulting than a single allocation base method.
b. Assuming the controller’s assumptions are correct (that benefits and
telecommunications costs are driven by headcount while rent is driven by
space occupied and general and administrative costs are driven by relative
sales), then the multiple cost pools provide better information on the resources
consumed and the profitability of the two divisions.
Chapter 6 Cost Allocation and Activity-Based Costing
P2. a. The opportunity cost of producing a Model 350 motor is simply the
incremental cost of production (given that Binder has excess capacity and
sales to Dacon will not affect sales to other customers).
Direct material
Direct labor
Variable overhead ($.80 × direct labor)*
* Variable overhead rate is equal to $4,000,000 of variable overhead ÷
$5,000,000 of direct labor.
b. Since 60 percent of the overhead is fixed ($12 per motor), the incremental cost
to produce the motors is $38 per motor ($20 + 10 + 8). Any bid greater than
$38 (that’s accepted) will generate incremental profit. If Binder can get the
order with a bid of $48, the company should bid this amount. It will generate
incremental profit of $50,000 [($48 - $38) × 5,000 motors].
c. The opportunity cost related to overhead, in this case, is simply the variable
overhead amount. An allocation based on the opportunity cost idea, helps
managers focus on incremental costs—the information needed for decision
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P3. a. Overhead rate based on direct-labor dollars
($50,000,000 overhead ÷ $5,000,000 labor)
Overhead rate based on machine hours
($50,000,000 overhead ÷ 500,000 machine hours)
Direct material
Direct labor
$ 2,000
$10 per dollar of labor
$100 per machine hour
$ 2,500
$ 2,500
b. The price charged for the civilian version of the Model KV10 does not
depend on allocated costs. However, the military version is sold for “cost”
plus 10 percent of cost. Therefore, the company has an incentive to make
cost appear higher rather than lower. This can be accomplished by
allocating overhead cost using direct labor cost as the allocation base. This
base results in a higher cost ($12,400) compared to an allocation based on
machine hours which results in a cost of only $11,400.
c. Many, if not most, managers believe that “it is well known that allocation
is somewhat arbitrary and the government is not at all surprised that
companies pick allocation bases to maximize their profit.” Since no one is
being “fooled,” the behavior is not illegal, and the “right” allocation isn’t
obvious, picking an allocation base to maximize profit does not appear to
be unethical.
Chapter 6 Cost Allocation and Activity-Based Costing
P4. a. Twenty percent of air miles are by Domestic (5,000,000 miles ÷
25,000,000 miles) and International flights accounts for 80 percent of the
total air miles. Therefore, Domestic flights will be allocated 20 percent of
the service departments’ costs and International will be allocated 80
Baggage handling
$ 4,000,000
Allocated to
$ 800,000
b. The best cause-and-effect relation is probably between maintenance costs
and air miles flown (the most suspect relation is between ticketing and air
miles flown—more miles do not lead to higher ticketing costs). Given that
international passengers have more baggage and have more transfers than
domestic flyers, the relation between baggage handling costs and air miles
flown is probably stronger than the relation between air miles and ticketing
but weaker than the relation between air miles and maintenance.
A better allocation base for ticketing might be number of tickets issued. A
better allocation base for baggage handling might be number of bags
Production department use of service
Service depts.
Maintenance ($400,000)
Computing ($600,000)
Service dept. costs allocated to Assembly:
(.7 × $400,000) + (.3333 × $600,000) = $280,000 + 200,000 = $480,000.
Service dept. costs allocated to Testing:
(.3 × $400,000) + (.6667 × $600,000) = $120,000 + 400,000 = $520,000.
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P6. a.
Allocation Base
Financial Planning
Proportion Amount
Business Consulting
Proportion Amount
b. Both headcount and salary appear to be plausible allocation bases, but they
result in very different allocations. This suggests that in many cases
allocations are somewhat arbitrary.
P7. a. Old overhead rate
Current overhead rate
($2,400,000 ÷ 150,000 direct labor hours)
$10 per labor hour
$16 per labor hour
Current overhead cost allocated to an 8 labor-hour job:
($16 × 8 labor hours)
Prior year overhead allocated to an 8 labor-hour job
($10 × 8 labor hours)
The current overhead cost for an 8 labor-hour job is 60% more than the prior
overhead cost.
b. Small jobs in the current year appear to be less profitable compared to the
prior year. This is because they are allocated overhead costs as if they
required use of the new equipment. Therefore, small jobs will be
overcosted. In all likelihood, the jobs do not really cost more than they did
in the prior year. One way to avoid miscosting of small (labor-intensive)
jobs would be to develop a separate overhead allocation rate for jobs that
are labor intensive and do not make use of the new equipment.
Chapter 6 Cost Allocation and Activity-Based Costing
P8. a. The recreation kayaks are uniform and probably made in large batches. The
competition kayaks are custom made one at a time. Several costs in the
overhead cost pool are probably less expensive on a per unit bases for
recreation versus competition kayaks. For example, each competition kayak
probably requires (on average) more equipment time, quality control, and
setup and drafting costs compared to each recreation kayak.
b. Summit needs to look at the costs of activities that each line of kayaks
requires. Summit could get more accurate costs if each of the major
overhead cost components were allocated to the kayak line using an
appropriate cost driver.
Cost Pool
$ 25,000
Materials ordering
Quality control
Maintenance & security 10,000
Set up and drafting
Per kayak
use of base allocation use of base allocation
$ 21,429
$ 3,571
Total unit costs for each model boat:
Direct materials
Direct labor
Total unit cost
Sales price
Gross Profit
$ 25.84
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d. The traditional allocation method used by Summit is essentially a volumebased method. In this problem, each unit of the competition kayak used the
same amount of direct labor as a recreation kayak, but required much more of
some overhead resources. For example, total competition kayaks accounted
for 10 percent of volume and required 10 percent of direct labor but needed
66.7 percent of set up and drafting resources. Using a single traditional
allocation base assumes that each product uses all overhead resources in the
same proportion that the allocation base is used. Except for supervision,
competition kayaks use more than 10 percent of overhead resources. Better
information will be provided by an ABC system. With an ABC system, cost
pools will be formed for key activities and overhead drivers (allocation bases)
need not be based on production volume.
P9. a.
Cost Pool
Materials ordering
Materials inspection
Equipment setup
Quality control
Overhead rate
$800,000 ÷ 100,000 = $8.00 / order
$400,000 ÷ 2,000 = $200 / rec. report
$2,000,000 ÷ 100 = $20,000 / setup
$900,000 ÷ 4,000 = $225 / inspection
$15,000,000 ÷ $10,000,000 = $1.50 / labor cost
b. Materials ordering
$8.00 per order × 1,000 orders =
$ 8,000
Materials inspection $200 per report × 300 reports =
Equipment setup
$20,000 per setup × 1 setups =
Quality control
$225 per inspection × 400 inspections = 90,000
$1.50 per labor dollar × $120,000 =
Total overhead assigned to Remote Mouse
c. Overhead rate per unit of Remote Mouse = $358,000 ÷ 20,000 units =
d. Total unit costs per unit of Remote Mouse = $31 + $6 + $17.90 = $54.90
e. With a traditional system:
The overhead rate per direct labor dollar is:
($19,100,000 ÷ $10,000,000 direct labor cost)
$1.91 per dollar of direct labor
Chapter 6 Cost Allocation and Activity-Based Costing
The direct labor cost, per unit, for the Remote Mouse:
($120,000 ÷ 20,000 units)
Overhead assigned to each unit of Remote Mouse
($1.91 × $6.00 direct labor cost)
ABC assigns $6.44 more overhead to each unit of Remote Mouse than is
assigned using a traditional production volume base. Remote Mouse
production uses only 1.2 percent of direct labor dollars, but requires 10
percent of materials ordering, 15 percent of materials inspection, and 10
percent of quality control resources. Remote Mouse production uses a
relatively a small amount of direct labor dollars and is therefore undercosted a
traditional approach to allocation.
P10. a. Cost to book travel (per completed trip):
$800,000 ÷ 20,000 completed trips = $40 per completed trip
The benchmark cost is $30 per completed trip. Thus, it appears that
Baxter’s costs are relatively high (33% more than the benchmark), and
process improvement is warranted.
b. The wages paid to employees who book travel are $630,000 (14 employees
× $45,000.
Number of completed trips booked:
1,000 consultants × 20 trips
20,000 trips
Number of trips booked but not necessarily completed:
1.30 × 20,000
26,000 trips
Bookings not completed
6,000 trips
Wage cost per trip booked but not necessarily completed:
$630,000 ÷ 26,000
Wage cost of trips not completed:
6,000 × $24.23
Savings if number can be reduced by 50 percent:
$145,380 × .5
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P11. a. A sophisticated Web site and call center can reduce demands placed on
tellers to process deposits, process withdrawals, deal with requests for
CDs, answer questions related to balances, and respond to requests for
statements. A sophisticated Web site or call center will not impact teller
time to provide access to safe deposit boxes or reconcile the cash drawer.
b. A sophisticated Web site, automatic cash machines, and call center
software that provides responses to common questions are examples of
technology that can reduce the cost of services provided by tellers.
P12. With 6,000 employees and turnover of 15%, 900 people leave the company
and 900 are added to take their place each year (.15 x 6,000). With this in
mind, having 6 employees to handle new employee training appears
excessive. Suppose each new employee requires a half day of training. That
implies 450 training days. Assume that each trainer works 5 days per week
for 48 weeks per year. Then, each trainer covers 240 training days. Thus,
only 2 trainers are needed (450 ÷ 240 = 1.875). Reducing trainers by 4 would
save $20,000 in salary each month.
Now, consider operations. It’s not clear that 5 clerks are needed. Suppose
paperwork related to resignations and new hires is 2 hours per person. This
implies a need for 3,600 hours (2 hours x 1,800 resignations or hires).
Assuming each clerk works 8 hours per day, with a 5 day work week for 48
weeks, a clerk has 1,920 hours. Again, it appears that only 2 clerks are
needed (3,600 ÷ 1,920 = 1.875). A reduction of 3 clerks would save $7,500
per month.
Based on the above analysis, which admittedly required some “ballpark”
assumptions, the low hanging fruit is in operations and training.
Note that the total savings is estimated to be $27,500 per month or $330,000
per year. Assuming the ABM study reduced waste for 3 years, the company
would save approximately $1,000,000. If similar savings could be found in
other departments, ABM would create substantial shareholder value.