Job System Cost Allocation

8/2/2019 Job System Cost Allocation

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Traditional

Cost ManagementSystems

Rishiraj


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Cost Management Systems (2 of 2) Since the mid-1980s companies have been

adopting activity-based costing (ABC) for productand customer costing

These three systems are often portrayed as

distinct; however, all cost systems work inessentially the same way: Expense categories are developed and then expenses

are mapped to service departments, production centers,

or activities Expenses are then attached to cost objects

The way these links are made and the activitiesdefined is what differentiates these systems


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Job Order v. Process Costing Systems

Ajob order costing system estimates the costsof manufacturing products for different jobsrequired for specific customer ordersApplicable in organizations that treat each individual job

as a single unit of output Aprocess costing system is applicable when all

units produced during a specified time frame aretreated as one unit of output Every unit made during the time period is essentially

identical


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Need for Job Order Costing

Products may differ Materials content

Hours of labor required

Machine time required

Demand placed on support activity resources (i.e.,manufacturing overhead)

Special customer needs that require customizedproduction

With such variety, managers need to understandthe costs of individual products so that they canassess product and customer profitability


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The Cost Flow Model

The cost flow model essentially uses aninventory concept to track costs Raw materials inventory

Work-in-process (WIP) inventory

Raw materials are transformed by labor and supportresources

Costs of the resources for each job not yetcompleted

Finished goods inventory When the goods are sold, they are accounted for

in the expense category Cost of Goods Sold


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Bidding Using Job Order Costing

Firms are sometimes required to bid onjobs before customers decide to place anorder with them

Costs need to be estimated for each job inorder to prepare a bid

Job order costing systems provide the

means to estimate these costs A job bid sheet provides a format for

recording the estimated costs


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Job Bid Sheet (1 of 6)

Panel 1 identifies the customer, theproduct, and the number of units required

Bid Number: J4369 Date: July 6, 2009

Customer: Ashok Motors

Product: Automobile engine valves (Valve #L181)

Engineering Design Number: JDR-103

Number of Units: 1,500


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Panel 2lists all the materials required tocomplete the job

Materials Quantity Price AmountBar steel stock 3 3,600 Kgs 11.30 40,680

Subassembly 1,500 39.00 58,500

Total direct materials 99,180


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Panel 3lists the amount of direct laborrequired for the job

Labor Hours Rate Amount

Lathe operators 480 26.00 12,480

Assembly workers 900 18.00 16,200Total direct labor 1,380 26,680


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Panel 4contains estimates for cost drivercosts

Support Costs Amount

600 machine-hours @ 40/hour 24,000

1,380 direct labor hours @ 36/hour 49,680Total support costs 73,680


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Panel 5summarizes the total costsestimated for the job

Direct material 99,180

Direct labor 28,680

Support costs 73,680Total costs 201,540


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A markup rate is applied to translate theestimated cost into a bid price

A 25% markup rate is assumed in this example

Total costs 201,540

Add 25% markup 50,385

Bid price 251,925Unit cost 134.36

Unit price 167.95


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Job Costs And Markup Most firms mark up the job costs by adding an

additional amount, or margin, to make a profit onthe job

The total job costs plus the margin equals thebid price

The markup rate depends on a variety of factors: The amount of support costs excluded from the cost

driver rate The target rate of return desired by the corporation Competitive intensity Past bidding strategies adopted by key competitors Demand conditions Overall product-market strategies


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Determination Of Cost Driver Rates

Determining realistic cost driver rates hasbecome increasingly important in recent years Support costs now comprise a large portion of the total

costs in many industries

Many firms now recognize that several differentfactors may be driving support costs rather thanone or even two factors, such as direct labor or

machine hours Firms are now taking greater care in identifying which

support costs should relate to what cost driver


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Cost Driver Rates

All costs associated with a cost driver, such assetup hours, are accumulated separately Each subset of total support costs that can be

associated with a distinct cost driver is referred to as a

cost pool Each cost pool has a separate cost driver rate

The cost driver rate is the ratio of the cost of asupport activity accumulated in the cost pool to

the level of the cost driver for the activityActivity cost driver rate =

Cost of support activity / Level of cost

driver


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Stable Cost Driver Rates (1of 2)

The cost of the support activity is the cost of theresources committed to the particular activity

The level of the activity cost driver is the long-term capacity made available by the amount of

resources committed to a support activity The cost of a support activity, therefore, excludes

fluctuations in costs caused by short-term adjustmentssuch as overtime payments

The level of the support activity cost driver alsoexcludes short-term variations in demand as reflectedin overtime or idle time


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Stable Cost Driver Rates (2of 2)

The ratio shown in the previous equationis based on costs and cost driver levels,the rate remains stable over time:

It does not fluctuate as activity levels changein the short run

It does not change simply because of short-run changes in external factors that do not

affect the efficiency or price of the activityresources


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Fluctuating Rates

For example, if the rate for machine costs isbased on quarterly cost driver levels instead ofthe normal levels: The rate increases as the demand for the machine

activity falls The rate decreases as the demand increases

In contrast, the cost driver rate based on costsand activity levels remains fixed throughout the

year Costs depend on the machine capacity made available

and not on the season


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Problems With Fluctuating Rates Determination of cost driver rates based on

short-term usage results in higher rates duringperiods of lower demand Job costs appearto be higher during time periods

when demand is lower

Bid prices based on estimated job costs are likely to behigher during periods of low demand when theyprobably should be lower

The higher bid price can further decrease demand,which in turn leads to higher cost driver rates and even

higher prices Conversely, in periods when demand is high and

capacity is short, job costs will appear to belower, and bid prices will also be low


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Number of Cost Pools The number of cost pools can vary

Some German firms use over 1,000 The general principle is to use separate cost

pools if the cost or productivity of resources isdifferent and if the pattern of demand varies

across resources The increase in measurement costs required by

a more detailed cost system must be traded offagainst the benefit of increased accuracy in

estimating product costs If cost and productivity differences between resources

are small, having more cost pools will make littledifference in the accuracy of product cost estimates


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Recording Actual Job Costs Job order cost accounting systems record costs

actually incurred on individual jobs as they areproduced This process allows comparison of actual costs with

the estimated costs

Copies of all materials requisition notes and

worker time cards are forwarded to theaccounting department, which then posts themon a job cost sheet

The system calculates total costs for the portionof the job completed

The structure of the job cost sheet is similar tothat of the job bid sheet The direct materials and direct labor costs on the job

cost sheet represent the jobs actual costs incurred


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Multistage Process Costing For many plants engaged in continuous processing

production flows continuously, semi-continuously,or in large batches from one process stage to thenext

At each successive process stage, there is further

progress toward converting the raw materials intothe finished product

In continuous processing it is necessary first todetermine costs for each stage of the process and

then to assign their costs to individual products


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Multistage Process Costing Systems

The design of product costing systems in such

process-oriented plants allows measurement ofthe costs of converting the raw materials duringa time period to be made separately for eachprocess stage

The conversion costs are applied to products asthey pass through successive process stages

This system for determining product costs,

known as a multistage process costing system,is common in process-oriented industries


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Process-Oriented Industries Multistage process costing systems are found in plants

engaged in continuous processing, such as those in thechemicals, basic metals, pharmaceuticals, grain millingand processing, and electric utilities industries

We also find multistage process costing systems in some

discrete-parts manufacturing plants such as thoseproducing automobile components, small appliances, andelectronic instruments and computers

The common feature in these settings is that the productsmanufactured are relatively homogeneous

Few and relatively small differences occur in theproduction requirements for batches of differentproducts


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Comparison With Job Order Costing

Both systems have the same objective:Assign material, labor, and manufacturingsupport activity costs to product

Process costing systems differ in thatthey:

Do not maintain separate cost records forindividual jobs

Measure costs only for process stages Determine cost variances only at the level of

the process stages instead of at the level of

individual jobs


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Job Order and MultistageProcess Costing (1 of 3)

In job order costingproduction is carriedout in different jobs

In multistage process costing,productionis carried out continuously, semi-continuously, or in large batches


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In job order costing,productionrequirements are different for eachindividual job

In multistage process costing,productionrequirements are homogeneous acrossproducts or jobs


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In job order costing, variances betweenactual and estimated direct material anddirect labor costs are determined for each

individual jobs In multistage process costing, variances

between actual and estimated costs are

determined for individual process stages


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Service Department

Cost AllocationsAppendix


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Operating Expense Allocations

Traditional cost accounting systemsassign operating expenses to productswith a two-stage procedure:

1. Expenses are assigned to productiondepartments

2. Production department expenses are

assigned to the products Departmental structure influences the

first-stage allocation process


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Effect Of Departmental Structure Many plants are organized into departments that are

responsible for performing designated activities Departments that have direct responsibility for

converting raw materials into finished products arecalledproduction departments

Service departments perform activities that supportproduction, such as:

Machine setup

Production engineering

Production scheduling

All service department costs are indirect supportactivity costs because they do not arise from directproduction activities

Machine maintenance


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Two-Stage Cost Allocation (1 of 2) Conventional product costing systems assign

indirect costs to jobs or products in two stages1. In the first stage:

System identifies indirect costs with variousproduction and service departments

Service department costs are then allocated toproduction departments

1. The system assigns the accumulated indirect

costs for the production departments toindividual jobs or products based onpredetermined departmental cost driver rates


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Two-Stage Cost Allocation (2 of 2)


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Allocating Service DepartmentCosts To Production Departments

There are three ways that companies allocateservice department costs to productiondepartments:

Direct allocation Sequential allocation

Reciprocal allocation

The last two are used when service departments

consume services provided by other departments(Examples based on PATIENTAID information in text)


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PATIENTAID EXAMPLEStep 1 of Stage 1 cost allocations (given)


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Direct Allocation Method The direct allocation method is a simple

method that allocates the servicedepartment costs directly to the productiondepartments

Allocations to production departments arebased on each production departmentsrelative use of the applicable cost driver

It ignores the possibility that some of the

activities of a service department may benefitother service departments as well asproduction departments


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Allocation Bases Values


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Allocation Ratios

300,000 / 1,200,000 = 0.250

Based on relative allocation basis value


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Allocation ofService Department Costs

Multiply service department cost by the allocation ratios

$160,000 x 0.250 = $40,000


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Stage 2 Cost Allocations Stage 2 allocations

Require the identification of appropriate cost drivers foreach production department

Assign production department costs to jobs andproducts while they are worked on in the departments

Conventional cost accounting systems use unit-related cost drivers, such as the number of unitsmade, the number of direct labor hours (or cost),and the number of machine hours

Dividing the indirect costs accumulated in eachproduction department by the total number ofunits of the corresponding cost driver results incost driver rates for each department


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PATIENTAID Stage 2 (1 of 2) The Casting Department allocates its indirect

costs to jobs based on machine hours, with totalcapacity for Casting equaling 6,000 machinehours

Total indirect costs for Casting, after theallocation from service departments in Step 2 ofStage 1 was $216,000

As a result, Casting allocates indirect costs to

jobs at a rate of $36.00 per machine hour= $216,000/6,000 hours

Each department will make a similar calculation


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PATIENTAID Stage 2 (2 of 2) If Job J189-4 uses 40 machine hours while in the

Casting Department, Casting will allocate $1,440of its indirect costs to Job J189-4= 40 hours x $36.00 per hour

Each department will allocate indirect costs to

Job J189-4 in a similar manner, and Casting willallocate some costs to all jobs in a similar manner To determine the total cost of Job J198-4, add the

Direct Material and Direct Labor cost assigned ineach department and the indirect cost allocated

from each department To determine the cost per unit, divide the total

cost by the number of units in Job J189-4

C t Di t ti i


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Cost Distortions inA Two-Stage Allocation (1 of 2)

The two-stage allocation can cause someproducts to be overcosted and othersundercosted if allocations are based on unitmeasures but the units of different products

have different relative consumption ratios In the Minnetka example in the textbook,

Products A and B use the same number ofmachine hours, resulting in an equal allocation of

indirect, including setup, costs per unit Product A, however, runs in larger batches, so

one units relative consumption of setupresources is lower for A than for B

C t Di t ti i


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Cost Distortions inA Two-Stage Allocation (2 of 2)

Cost distortions are greater when the differencebetween the relative proportion of the cost driverfor the activity (e.g., setup hours) and therelative proportion of the basis for second-stageassignment of support costs (e.g., machine

hours) is greater Such distortions could be eliminated if the

costing system used the actual cost driver foreach support activity to assign costs directly to

the products This logic underlies the development of activity-based costing systems discussed in thefollowing chapter


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Sequential and ReciprocalAllocation Methods

Sequential and reciprocal allocationmethods are used when servicedepartments consume services provided

by other service departments The sequential allocation method allocatesservice department costs to one servicedepartment at a time in sequential order

The reciprocal allocation method determinesservice department cost allocationssimultaneously


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Sequential Allocation Method (1 of 5)

The sequential method is appropriatewhen there is not a pair of servicedepartments in which each department inthat pair consumes a significant proportionof the services produced by the otherdepartment in that pair


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The sequential allocation method requires

that the service departments first bearranged in order

A service department can receive costs

allocated from another service departmentonly before its own costs have been allocatedto other departments

Once a service departments costs havebeen allocated, no costs can be allocatedback to it from other departments


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Sequential Allocation Method (3 of 5)Service

DepartmentsProduction

Departments

Item Power Engineering Machining Assembly Totals

Services Used:

Kilowatt hours

Engring hours

0

0

100,000

0

480,000

2,000

220,000

2,000

800,000

4,000

Allocation ratios:

Power

Engineering

0

0

0.125

0

0.600

0.500

0.275

0.500

1.000

1.000

Directly identifiedcosts

$320,000 $180,000 $120,000 $80,000 $700,000

480,000/800,000 = 0.600

2,000/4,000 = 0.500


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Sequential Allocation Method (4 of 5)Service Departments Production

DepartmentsItem Power Engineering Machining Assembly Totals

Directly identifiedcosts $320,000 $180,000 $120,000 $80,000 $700,000

Cost Allocations:Power

Engineering

(320,000)

0

40,000

(220,000)

192,000

110,000

88,000

110,000

Totals $ 0 $ 0 $ 422,000 $ 278,000 $ 700,000

$320,000 * 0.600 = $ 192,000

($180,000 + 40,000) * 0.500 = $ 110,000


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In this example, the power department does notreceive engineering services, but theengineering department uses power

Therefore, in the sequential method:

The power department costs are allocated first Then the engineering department costs are allocated

The total cost of a service department allocatedto other departments equals the amount directly

identified with the service department plus theamount allocated earlier to the servicedepartment from other service departments

R i l All i M h d


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Reciprocal Allocation Method (1 of 6) If both service departments in this

example consume each others services,the reciprocal allocation method isappropriate

The sequential method ignores orsuppresses such reciprocal relations

The reciprocal allocation methodrecognizes reciprocal interactions between

different service departments The example changes only to recognize

Powers use of Engineerings services


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Reciprocal Allocation Method (2 of 6)Service

DepartmentsProduction

Departments

Item Power Engineering Machining Assembly Totals

Services Used:

Kilowatt hours

Engring hours

0

1,000

100,000

0

480,000

2,000

220,000

2,000

800,000

5,000

Allocation ratios:

Power

Engineering

0

0.200

0.125

0

0.600

0.400

0.275

0.400

1.000

1.000

Directly identifiedcosts

$320,000 $180,000 $120,000 $80,000 $700,000

480,000/800,000 = 0.600

2,000/5,000 = 0.400


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Reciprocal Allocation Method (3 of 6)

Before allocating any costs to the production

departments, determine the reciprocalallocation between service departments:

Powers total cost is $320,000 + 20% of the total

cost of Engineering (P=320,000+.20E) Engineerings total cost is $180,000 + 12.5% of

the total cost of Power (E=180,000+.125P)

Solve the simultaneous equations bysubstitution

R i l All ti M th d


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Reciprocal Allocation Method (4 of 6)

P=320,000+.20E, with E=180,000+.125P

P=320,000+.20(180,000+.125P)

P=320,000 + 36,000 + .025P

.975P=320,000 + 36,000

P= $ 365,128

E=180,000+.125P

E=180,000+.125(365,128)

E=180,000+45,641

E= $ 225,641

These costs will beallocated to theproductiondepartments using

the allocation ratiosshown previously


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Reciprocal Allocation Method (5 of 6)Service Departments Production

DepartmentsItem Power Engineering Machining Assembly Totals

Directly identifiedcosts $320,000 $180,000 $120,000 $80,000 $700,000

Cost Allocations:Power

Engineering

(365,128)

45,128

45,641

(225,641)

219,077

90,256

100,410

90,257

Totals $ 0 $ 0 $ 429,333 $ 270,667 $ 700,000

($320,000 + 45,128) * 0.600 = $ 192,000

($180,000 + 45,641) * 0.400 = $ 110,000


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Fi l W d T St All ti


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Final Word on Two-Stage Allocation The fundamental assumption of the two-stage allocation

method is the absence of a strong direct link between the

support activities and the products manufactured For this reason, service department costs are first

allocated to production departments using one of theconventional two-stage allocation methods previouslydescribed

Activity-based costing rejects this assumption and insteaddevelops the idea of cost drivers that directly link theactivities performed to the products manufactured andmeasure the average demand placed on each activity by thevarious products

Activity costs are assigned to products in proportion to theaverage demand that the products place on the activities,usually eliminating the need for the second step in Stage1 allocations


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