Managerial Accounting Balakrishnan | Sivaramakrishnan | Sprinkle | Carty | Ferraro Chapter 9: Cost...

Managerial AccountingBalakrishnan | Sivaramakrishnan | Sprinkle | Carty |

Ferraro

Prepared by Debbie Musil, Kwantlen Polytechnic University

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

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

Dinner bill # of persons Total # of persons Each family

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

•


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?


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 labour 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 labour 75 150Variable marketing & sales 24 72Unit Contribution Margin $256 $303

Mattress Type

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:


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

Estimating Cost of Capacity • Two approaches:

−Direct estimation, or−Use allocations to approximate costs

• 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 ……


Example (Revisited)

• Expert 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 M− Suppose we allocate based on labour $

• Labour 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 labour $


$1,350,000 $1,800,000

42.86% 57.14%

$3,240,000 $4,320,000

42.86% 57.14%

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

• Estimated labour 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.


Revised Profit Estimate

Changing the mix is not a good idea!

Changing the mix is not a good idea!


How We Allocate Matters• Suppose we used units (i.e., a mattress) as the basis for

allocation (and not labour hours)

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

• New mix: − 10,000 units of standard, and

− 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 also does not change


$7,560,000 / 30,00011

$25211

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

Explanation for Check It! Exercise #2• The total does not change because we have

30,000 units under both the current and projected mix

• 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 labour time, which, in turn, leads to greater use of the factory’s capacity

Refining the Allocation• We can account for the makeup of the

capacity cost−Use more cost pools to account for different

kinds of capacity cost−$7,560,000 = $5,040,000 (manufacturing)

+ $2,520,000 (marketing)−Not reasonable to assume both pieces vary

with labour $• Units may be better for Marketing allocation

• We can use different drivers for different pools to improve our prediction−Manufacturing (allocate with labour $) −Marketing (allocate with units)


Estimated Profit (Two Pool System)


Example (wrap up)• Overhead rates

−Manufacturing - $1.60/labour $

−Marketing - $84.00/unit

• Revised capacity cost− Manufacturing $3.75 M x $1.60/labour $ = $6.00 M

− Marketing 30 K units x $84 /unit = $2.52 M

− Total = $8.52 M

• 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


Why do We Need This Allocation?• Required by GAAP

−Requires the use of absorption costing• Separates product and period costs

−Manufacturing costs inventoriable• Pertain to units made

•Product cost / Inventoriable cost

−Marketing and sales costs are expensed• Pertain to units sold

•Period cost

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

We Allocate Costs for Many Reasons


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

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


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

Comparing Profit• All costs and revenues except for one type

of cost are accounted for the 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


Reimbursements• Firms use allocations to justify costs

and reimbursements

−Travel

−Defense contracting

−Hospital rates

• Choice of basis will affect amount reimbursed

−Firms have incentives to be strategic in the choice of allocation procedures

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

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 $4.00 per unitUse of Machine hrs 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 $4.00 per unitUse of Machine hrs 60% 40% of totalPrice $8.00 Cost plus 20%

Common fixed cost $8,000,000


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.

Influencing Behavior

• Allocations can influence the use of resources−Can discourage the use of one resource in

favour of another

• Allocated cost behaves like a variable cost−From department manager’s perspective

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

• Reduce demand for labour

−Allocate based on materials cost• Incentives to in-source


Allocationscan Modify Behaviour


Inducing Efficient Use

• Use allocations to discourage wasteful use−Sensitize users to the cost of a resource

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

• We can use this property to−Publicize the “cost” of a resource

• So resource is not considered to be free of charge

−Induce desired behavior• Use some measure correlated with use as the basis


Choices Depend on Why We Allocate


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 being used


AppendixVariable Costing• Income is determined by:

−Sales−Unit contribution margin−Fixed costs

• Increases/decreases in inventories

does not affect reported income

• However, not acceptable under

financial accounting standards

Absorption Costing• Separates product costs from period costs

• Allocates fixed manufacturing costs to units

produced−Product not sold at end of period will contain

some of this fixed cost

• Provides an incentive to overproduce−Inventorying fixed costs will cause income to

be higher−This effect is illusory – the costs are “hidden” in

inventory

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?

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.

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


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.



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.



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)

Copyright © 2011 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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