1. 2 We Allocate Costs for Many Reasons LO1: Understand how to use cost allocations to make long-term decisions

1

2

We Allocate Costs for Many Reasons

LO1: Understand how to use cost allocations to make long-term decisionsLO1: Understand how to use cost allocations to make long-term decisions

3

What is an Allocation? (Review)• To distribute a common cost or benefit among

different items Dinner bill among friends Rent among roommates Overhead costs among products Salesperson salary among customers Sales revenue among bundled products

• Mechanics [Split $80 among two families (2 and 3 people)] Cost Pool Allocation basis Denominator volume Cost object


Dinner bill # of persons Total # of persons Each family

4

Steps in Every Allocation• Divide cost in pool by denominator volume to

get allocation rate $80 / 5 persons = $16 per person

• Multiply rate by the number of driver units in cost object to determine allocated cost 3 persons * $16/person = $48 2 persons * $16/person = $32

• Properties of allocations Driver units must be traceable at the level of the cost

object % cost allocated = % driver units

60% of cost to family 1 3 of 5 persons from family 1


5

Allocations for Decision Making

• Use to estimate change in controllable capacity costs

• Let us consider an example EZ rest is currently making 18,000 standard and

12,000 deluxe mattresses. What is the expected profit if EZ-Rest changes its

product mix to make 10,000 standard and 20,000 deluxe mattresses?


6

EZ Rest Company: Basic Data

Standard Deluxe TotalSales volume (in units) 18,000 12,000 30,000Revenue $11,700,000 $10,500,000 $22,200,000Variable Costs

Direct materials $5,310,000 $4,200,000 $9,510,000Direct labor 1,350,000 1,800,000 3,150,000Marketing & sales 432,000 864,000 1,296,000

Contribution margin $4,608,000 $3,636,000 $8,244,000Fixed Costs

Manufacturing $5,040,000Marketing & sales 1,560,000Administration 960,000

Profit before taxes $684,000Unit-level Data Standard DeluxeSelling price $650 $875Direct materials 295 350Direct labor 75 150Variable marketing & sales 24 72Unit Contribution Margin $256 $303

Mattress Type

7

What is Profit with New Mix?

• Suppose we wish to change the product mix to 10,000 Standard and 20,000 deluxe mattresses. What is the profit with the new mix?

• One estimate is as below:


Contribution margin (Standard) 10,000 × $256/unit $2,560,000

Contribution margin (Deluxe) 20,000 × $303/unit $6,060,000

Total contribution margin $8,620,000

Fixed costs ($7,560,000)

Profit $1,060,000

8

$1,350,000 $1,800,00042.86% 57.14%

$3,240,000 $4,320,00042.86% 57.14%

9

Should We Change the Mix?

• This estimate is probably wrong! Dealing with long-term decisions

Capacity cost is controllable over this decision horizon

Profit margin is correct measure to use

• But, capacity cost is: Common across many products

Lumpy

• How to estimate the change in capacity costs?


10

Estimating Change in Capacity Cost • Need model of how costs will change

Can do direct estimation Can employ allocations to approximate

change Similar to use of High-Low method in short-term

decisions

• Allocated cost is estimate of Change in capacity cost due to change in

Product volume and/or product mix Customer volume and / or mix Activity volume ……


11

Example (Revisited)

• Experts estimate (using account analysis) is that capacity costs would increase by $890,000. Good idea for large decisions / new endeavors Tedious and difficult to do

• How do allocations help? Cost pool is overhead cost of $7.56 MM Suppose we allocate based on labor $

Labor cost is the allocation basis or cost driver Denominator volume = $3,150,000

(18,000 standard x $75 / standard mattress) + (12,000 deluxe x $150/deluxe mattress)

Rate = $7,560,000/$3,150,000 = $2.40 per labor $


12

Estimated Capacity Cost • New Mix: 10,000 standard, & 20,000 deluxe

• Estimated labor cost with new mix

$3, 750,000 = 10,000 std x $75/unit + 20,000 deluxe x

$150/unit

• Estimated overhead cost

$3,750,000 x $2.40 / labor $ = $9,000,000

• Changing product mix increases capacity cost by $1.44 MM from $7.56 million to $9 million.


13

Revised Profit Estimate

Changing the mix is not a good idea!

Changing the mix is not a good idea!


Standard Deluxe Total

Sales volume (in units) 10,000 20,000 30,000

Revenue $6,500,000 $17,500,000 $24,000,000

Direct materials 2,950,000 7,000,000 9,950,000

Direct labor 750,000 3,000,000 3,750,000

Variable marketing & sales 240,000 1,440,000 1,680,000

Contribution margin $2,560,000 $6,060,000 $8,620,000

Allocated fixed costs 1,800,000 7,200,000 9,000,000

Profit Margin $760,000 ($1,140,000) ($380,000)

Mattress Type

14

How We Allocate Matters

• Suppose we used units (i.e., a mattress) as the basis for allocation (and not labor hours)

• Rate = $7,560,000 / (18,000+12,000) units = $252/unit

• New mix: 10,000 units of standard,

20,000 units of deluxe

• New estimated overhead cost$7,560,000

= 10,000 std x $252/unit + 20,000 deluxe x $252/unit

• Why no change in profit? Allocation basis does not distinguish among kinds of mattresses

Total number of mattresses has not changed. Thus, estimate based on allocation too does not change


15

$7,560,000 / 30,00011

$25211

$2,520,000 $5,040,000

16

Explanation for Check It! Exercise #2

• The total does not change because we have 30,000 units both under the current and projected mix.

• Furthermore, when we choose units as the allocation basis, the fixed overhead estimate is proportional to total units.

• This estimate is likely to be erroneous because manufacturing capacity costs are not likely to be related to units sold— that is, Standard and Deluxe mattresses consume varying amounts of resources.

• As discussed in the text, the Deluxe mattresses use much more labor time, which, in turn, leads to greater use of the factory’s capacity.

17

Improving Estimate• We can account for the makeup of the capacity

cost We can use more cost pools to account for different

kinds of capacity cost

$7,560,000 = $5,040,000 (mfg) + $2,520,000 (SG&A)

Not reasonable to assume both pieces vary with labor $ Units may be better for SG&A

• We can use different drivers for different pools to improve our prediction Manufacturing (allocate with labor $)

SG&A (allocate with units)


18

Total fixed costs$7,560,000


Marketing cost pool

$2,520,000

Marketing cost pool

$2,520,000

Manufacturing cost pool

$5,040,000

Manufacturing cost pool

$5,040,000



Standard$3,240,000Standard$3,240,000

Deluxe$4,320,000Deluxe$4,320,000

Standard $2,160,000+ $1,512,000= $3,672,000

Standard $2,160,000+ $1,512,000= $3,672,000

Deluxe $2,880,000+ $1,008,000= $3,888,000

Deluxe $2,880,000+ $1,008,000= $3,888,000

Panel A

Panel B


Direct Labor cost ($2.40 / DL$)

Labor cost ($1.60/DL$)

Units ($84/unit)

19

Estimated Profit (Two Pool System)


Detail Standard Deluxe Total

Sales volume (in units) 10,000 20,000 30,000Revenue 10,000 x $650;

20,000 x $875 $6,500,000 $17,500,000 $24,000,000Variable costs 10,000 x $394

20,000 x $572 3,940,000 11,440,000 15,380,000Contribution margin $2,560,000 $6,060,000 $8,620,000Estimated fixed costs (Manufacturing)

10,000 x $75 x $1.6020,000 x $150 x $1.60 1,200,000 4,800,000 6,000,000

Estimated fixed costs (Marketing)

10,000 x $84;20,000 x $84 840,000 1,680,000 $2,520,000

Profit before Taxes $520,000 ($420,000) $100,000

Mattress TypeDetail Standard Deluxe Total

Sales volume (in units) 10,000 20,000 30,000Revenue 10,000 x $650;

20,000 x $875 $6,500,000 $17,500,000 $24,000,000Variable costs 10,000 x $394

20,000 x $572 3,940,000 11,440,000 15,380,000Contribution margin $2,560,000 $6,060,000 $8,620,000Estimated fixed costs (Manufacturing)

10,000 x $75 x $1.6020,000 x $150 x $1.60 1,200,000 4,800,000 6,000,000

Estimated fixed costs (Marketing)

10,000 x $84;20,000 x $84 840,000 1,680,000 $2,520,000

Profit before Taxes $520,000 ($420,000) $100,000

Mattress Type

20

Example (wrap up)• Overhead rates

Manufacturing - $1.60/labor $

Marketing - $84.00/unit

• Revised capacity cost Manufacturing $3.75 MM x $1.60/labor$ = $6.00 MM

Marketing 30 K units x $84 /unit = $2.52 MM

Total = $8.52 MM

• Revised profit = $100,000

• We can refine with more pools if needed As we increase number of pools, the allocation

begins to resemble direct estimation


21

ALLOCATIONS FOR VALUING INVENTORY

22

Why do We Need This Allocation?

• Required by GAAP Determine inventory values

• Matching principle Manufacturing costs inventoriable

Pertains to units made

Product cost / Inventoriable cost

SGA cost is expensed Pertains to units sold

Period cost

LO2: Explain how cost allocations affect LO2: Explain how cost allocations affect income.income.

23

11

22

$4,352,000 / 17,00011

$3,514,800 / 11,60022

Thus, the contribution lost because of the lower sales volume (relative to the volume in Exhibit 9.1) is:

(1,000 Standard x $256) + (400 Deluxe x $303 per mattress) = $377,200.

33

$256$303

33

$7,560,000

24

In Income Statement In Balance Sheet

Produce unitsStandard: 18,000

unitsDeluxe: 12,000 units

Produce unitsStandard: 18,000

unitsDeluxe: 12,000 units

Panel A: Physical flow of units

Spend $5,040,000 on fixed

manufacturing overhead

Panel B: Variable Costing

Expense the entire amount

$5,040,000

Sell unitsStandard: 17,000 unitsDeluxe: 11,600 units


Put units into inventory

Standard: 1,000 unitsDeluxe: 400 units

Put units into inventory

Standard: 1,000 unitsDeluxe: 400 units

Always zero dollars

into inventory

Always zero dollars

into inventory

Flow of Costs in Variable Costing


25 LO2: Explain how cost allocations affect LO2: Explain how cost allocations affect income.income.

Income Statement Standard Deluxe Total

Production volume (in units) 18,000 12,000 30,000Sales volume (in units) 17,000 11,600 28,600

Revenue $11,050,000 $10,150,000 $21,200,000 Variable Costs Manufacturing $6,290,000 $5,800,000 $12,090,000 Marketing & sales 408,000 835,200 $1,243,200 Contribution Margin $4,352,000 $3,514,800 $7,866,800 Fixed Costs Manufacturing overhead $5,040,000

2,520,000Profit before Taxes $306,800 Unit-Level Data Standard Deluxe

Direct materials 295 350Direct labor 75 150Inventoriable cost per unit $370 $500 × # of units in inventory 1,000 400Value of inventory (total) $370,000 $200,000 $570,000

SGA costs



Revenue $11,050,000 $10,150,000 $21,200,000 Variable Costs Manufacturing $6,290,000 $5,800,000 $12,090,000 Marketing & sales 408,000 835,200 $1,243,200 Contribution Margin $4,352,000 $3,514,800 $7,866,800 Fixed Costs Manufacturing overhead $5,040,000

2,520,000Profit before Taxes $306,800 Unit-Level Data Standard Deluxe

Direct materials 295 350Direct labor 75 150Inventoriable cost per unit $370 $500 × # of units in inventory 1,000 400Value of inventory (total) $370,000 $200,000 $570,000

SGA costs

26

Flow of Costs in Absorption Costing


In Income Statement In Balance Sheet

Panel C: Absorption Costing

Produce unitsStandard: 18,000 unitsDeluxe: 12,000 units

Produce unitsStandard: 18,000 unitsDeluxe: 12,000 units

Panel A: Physical flow of units

Spend $5,040,000 on

fixed manufacturing

overhead

Allocate to products

Standard: $120/unitDeluxe: $240/unit

1,000 Standard * $120/unit

+ 400 Deluxe *240/unit

= $216,000

7,000 Standard * $120/unit

+ 11,600 Deluxe * $240/unit

= $4,824,000



Put units into inventory Standard: 1,000 units

Deluxe: 400 units

Put units into inventory Standard: 1,000 units

Deluxe: 400 units

27 LO2: Explain how cost allocations affect LO2: Explain how cost allocations affect income.income.



Revenue $11,050,000 $10,150,000 $21,200,000

Product Costs

Variable costs $6,290,000 $5,800,000 $12,090,000

Manufacturing overhead 2,040,000 2,784,000 $4,824,000 Gross Margin $2,720,000 $1,566,000 $4,286,000

Period Costs

Variable marketing & sales 408,000 835,200 $1,243,200

2,520,000Profit before Taxes $522,800

Unit-Level Data Standard Deluxe

Direct materials 295 350

Direct labor 75 150

Allocated overhead $120 $240

Inventoriable cost per unit 490 740

× # of units in inventory 1,000 units 400 units

Value of inventory (total) 490,000 296,000 786,000

Fixed SG&A

28

a) Be the same as it would be under absorption costing

b) Be less than it would be under absorption costing

c) Be equal to the net operating income using absorption costing plus selling and administrative costs

d) Be equal to the net operating income using absorption costing less fixed manufacturing costs

Test Your Knowledge!If a company produces more units than it sells in a period, net operating income under variable costing will:

29

Comparing Profit

• All costs and revenues but for one kind of cost are accounted for in same way

• Fixed manufacturing overhead costs

Expensed under variable costing

Allocated to products under absorption costing when units are MADE

Expensed only when units are SOLD

Timing difference with inventory


30

a) Direct materials

b) Variable manufacturing overhead

c) Fixed manufacturing overhead

d) Direct labor

Test Your Knowledge!When using variable costing which of the following is not considered a product cost?

31

Reconciling Income


Income reported under variable costing $306,800+ Fixed manufacturing costs in ending inventory 216,000– Fixed manufacturing costs in beginning inventory 0= Income reported under absorption costing $522,800

Standard Deluxe TotalUnits put into inventory 1,000 400Overhead per unit $120 $240Total $120,000 $96,000 $216,000

Detail of overhead put into inventory

32

Effect on Incentives

• Under Variable costing Focus on controllability Only sales affect income

• Under absorption costing Focus on inventory valuation Both sales and production affect income Increase income by increasing production!


33

ALLOCATIONS: INCENTIVE EFFECTS

34

Reimbursements

• Costs common among reimbursable and non-reimbursable reasons

Travel

Defense contracting

Hospital settings

• Choice of basis will affect amount reimbursed

Incentives to be strategic!

LO3: Describe the role of incentives in the choice of allocation procedures. LO3: Describe the role of incentives in the choice of allocation procedures.

35

Example• Ryan Supply Systems

Can allocate fixed costs via units or machine hours Which is the preferred (profit maximizing)

mechanism?

Public MilitarySales 2,000,000 2,000,000Variable cost $5.00 $4.000 per unitM/c hours 60% 40% of totalPrice $8.00 Cost plus 20%

Common fixed cost $8,000,000

Public MilitarySales 2,000,000 2,000,000Variable cost $5.00 $4.000 per unitM/c hours 60% 40% of totalPrice $8.00 Cost plus 20%

Common fixed cost $8,000,000


36 LO3: Describe the role of incentives in the choice of allocation procedures. LO3: Describe the role of incentives in the choice of allocation procedures.

Unit Data(Public/Military)

Sales volume (in units) 2,000,000 2,000,000 Panel A: Using Units as the Allocation Basis Revenue $8.00 / $7.20 $16,000,000 $14,400,000 $30,400,000 Variable costs $5.00 / $4.00 10,000,000 8,000,000 18,000,000Allocated fixed costs $2.00 / $2.00 4,000,000 4,000,000 8,000,000 Gross Margin $2,000,000 $2,400,000 $4,400,000

Panel B: Using Machine Hours as the Allocation Basis

Revenue $8.00 /$6.72 $16,000,000 $13,440,000 $29,440,000 Variable costs $5.00 /$4.00 10,000,000 8,000,000 18,000,000Allocated fixed costs 60% / 40% 4,800,000 3,200,000 8,000,000Gross Margin $1,200,000 $2,240,000 $3,440,000

Ryan Supply Systems: Condensed Income StatementsPublic Military Total Unit Data

(Public/Military)

Sales volume (in units) 2,000,000 2,000,000 Panel A: Using Units as the Allocation Basis Revenue $8.00 / $7.20 $16,000,000 $14,400,000 $30,400,000 Variable costs $5.00 / $4.00 10,000,000 8,000,000 18,000,000Allocated fixed costs $2.00 / $2.00 4,000,000 4,000,000 8,000,000 Gross Margin $2,000,000 $2,400,000 $4,400,000

Panel B: Using Machine Hours as the Allocation Basis

Revenue $8.00 /$6.72 $16,000,000 $13,440,000 $29,440,000 Variable costs $5.00 /$4.00 10,000,000 8,000,000 18,000,000Allocated fixed costs 60% / 40% 4,800,000 3,200,000 8,000,000Gross Margin $1,200,000 $2,240,000 $3,440,000

Ryan Supply Systems: Condensed Income StatementsPublic Military Total

37

Behavior Modification

• Allocations modify behavior Can induce desired actions Make undesired actions costly

• Allocation is like a “tax” Increases the cost of the driver unit

• If “price” increases, demand decreases Allocate on labor hours / labor cost

Reduce demand for labor

Allocate based on materials cost Incentives to in-source


38

The allocation rate is $80 per machine hour. Thus, $4,400,000 would be allocated to public meals (= 0.55 x $8,000,000), and $3,600,000 would be allocated to the military contract (= 0.45 x $8,000,000). The gross

margin for public meals is therefore $1,600,000 (= $16,000,000 - $10,000,000 - $4,400,000). The gross margin for the military is

$2,320,000 (= [$8,000,000 + $3,600,000] x 0.20). The total gross margin = $1,600,000 + $2,320,000 = $3,920,000, which is still lower than the $4,400,000 total gross margin using meals as the allocation basis.

The allocation rate is $80 per machine hour. Thus, $4,400,000 would be allocated to public meals (= 0.55 x $8,000,000), and $3,600,000 would be allocated to the military contract (= 0.45 x $8,000,000). The gross

margin for public meals is therefore $1,600,000 (= $16,000,000 - $10,000,000 - $4,400,000). The gross margin for the military is

$2,320,000 (= [$8,000,000 + $3,600,000] x 0.20). The total gross margin = $1,600,000 + $2,320,000 = $3,920,000, which is still lower than the $4,400,000 total gross margin using meals as the allocation basis.

39

Allocations are a “Tax”


40

Strategic Allocations

• By choosing pools and drivers strategically, we can use allocations to increase the amount cost allocated to some products

Of course, costs for other products will decrease

• Such allocations might be useful if one set of items has cost based pricing or reimbursements

Example: Defense contracting


41

Allocations and Behavior

• We can use this property to Sensitize users to the long-term cost of a resource

Cost of support departments such as IT are allocated even if “fixed” in the short term

Discourage undesired behavior Use some measure correlated with use as the basis Use will go down as the “price” for the measure has

increased

Encourage desired behavior Suppose we want to tradeoff labor for materials cost Using labor as an allocation basis provides the incentives

to employees


42

WRAP UP

43

Choices Depend on Why We Allocate


44

Conclusion• Allocations pervasive in organizations

• Multiple reasons for why organizations allocate common costs Only decision making related to controllability

Incentives drive the other demands for allocations

• Same allocation used for multiple purposes

When using allocations to make decisions Be aware of how allocations might help

How the validity of the choices affect estimated capacity cost

Consider incentive effects of the allocation mechanism in place


45

Exercise 9.32Increase in volume of business and cost projections (LO1). David Sharma sells masks, textiles, and other goods imported from Africa. David usually marks up his purchases by 300% (that is, if he pays $10 for an item, he lists it at $40). His annual sales range from $1,400,000 to $1,700,000, with sales for the current year expected to be $1,500,000. He also incurs fixed costs related to the rental for his store, travel, and other items. Such fixed costs generally amount to $900,000 per year.Required:

a) Suppose David anticipates sales of $1,700,000 next year. Calculate his expected profit for the current year and for next year, assuming that he does not change his pricing strategy. Use the contribution margin format.

b) Suppose David anticipates sales of $2,800,000 next year because he expects African art to come into “fashion.” Calculate expected profit. The new level of fixed costs is $1,600,000.

c) Why is it reasonable to think of fixed costs as being controllable when computing the answer for part (b) but not for part (a)? How might David reasonably estimate the “fixed” costs if he expects sales of $2,800,000 next year?

46

a) Suppose David anticipates sales of $1,700,000 next year. Calculate his expected profit for the current year and for next year, assuming that he does not change his pricing strategy. Use the contribution margin format.

The following table provides the required income statements. The following table provides the required income statements.

Exercise 9.32 (Continued)

Amount Amount

(current year) (next year)

Revenue $1,500,000 $1,700,000

Cost of Goods sold (25% of sales) 375,000 425,000

Contribution $1,125,000 $1,275,000

Fixed costs 900,000 900,000

Profit before taxes $225,000 $375,000

Contribution Margin StatementItem

Notice that fixed costs remain at $900,000 even though the volume of operations has increased. This is a reasonable assumption – while fixed costs might increase some, they are not likely to increase dramatically

because of a modest increase in sales.

Notice that fixed costs remain at $900,000 even though the volume of operations has increased. This is a reasonable assumption – while fixed costs might increase some, they are not likely to increase dramatically

because of a modest increase in sales.

47

b) Suppose David anticipates sales of $2,800,000 next year because he expects African art to come into “fashion.” Calculate expected profit. The new level of fixed costs is $1,600,000.

The following table provides the required statement. The following table provides the required statement.


Amount Amount

(current year) (next year)

Revenue $1,500,000 $2,800,000

Cost of Goods sold (25% of sales) 375,000 700,000

Contribution $1,125,000 $2,100,000

Fixed costs 900,000 1,600,000

Profit before taxes $225,000 $500,000

Contribution Margin Statement

Item

48


Our view of “fixed” costs changes based on the volume of operation. David seems to have a normal range of operations

of about $1.5 million. His fixed costs of $900,000 support operations at this level. However, the capacity provided by this

expenditure is unlikely to support a much higher volume of sales. For instance, David might need to make more trips,

spend more on stocking and tracking inventory, hire additional sales persons, open a branch outlet, and so on. All of these

actions contribute to higher fixed costs.

Our view of “fixed” costs changes based on the volume of operation. David seems to have a normal range of operations

of about $1.5 million. His fixed costs of $900,000 support operations at this level. However, the capacity provided by this

expenditure is unlikely to support a much higher volume of sales. For instance, David might need to make more trips,

spend more on stocking and tracking inventory, hire additional sales persons, open a branch outlet, and so on. All of these

actions contribute to higher fixed costs.


49


This problem reinforces that “fixed” costs are fixed only for a given volume of operations and for a given time frame. These costs do become controllable if we significantly change the

volume of operations or consider a long time frame. In David’s case, estimating the higher fixed cost might be hard. One reasonable approach is to say that fixed costs are 60% of

sales revenue ($900,000/$1,500,000). Then, at a volume of $2.8 million in sales, David would estimate fixed costs at

$1,680,000.

This problem reinforces that “fixed” costs are fixed only for a given volume of operations and for a given time frame. These costs do become controllable if we significantly change the

volume of operations or consider a long time frame. In David’s case, estimating the higher fixed cost might be hard. One reasonable approach is to say that fixed costs are 60% of

sales revenue ($900,000/$1,500,000). Then, at a volume of $2.8 million in sales, David would estimate fixed costs at

$1,680,000.


50


Note: Part (b) provides an estimate of $1.6 million toward fixed costs. The difference underscores that using an allocation to project capacity costs assumes that the underlying relation

would be the same. In David’s case, it is likely that, because of scale economies, fixed costs do not increase proportionately

with sales volume. Methods such as direct estimation are better equipped to deal with such effects, but require more

effort and expertise.

Note: Part (b) provides an estimate of $1.6 million toward fixed costs. The difference underscores that using an allocation to project capacity costs assumes that the underlying relation

would be the same. In David’s case, it is likely that, because of scale economies, fixed costs do not increase proportionately

with sales volume. Methods such as direct estimation are better equipped to deal with such effects, but require more

effort and expertise.

Exercise 9.32 (Concluded)

Documents

1. 2 We Allocate Costs for Many Reasons LO1: Understand how to use cost allocations to make long-term decisions