5
Cost Allocation and
Activity-Based Costing
Systems
Cost Allocation and
Activity-Based Costing
Systems
L E A R N I N G O B J E C T I V E S
After studying this chapter, you will be able to
1. Explain the major purposes for allocating costs.
2.Explain the relationship between activities, resources, costs, and cost drivers.
3.Use recommended guidelines to charge the variable and fixed costs of service departments to other organizational units.
4. Identify methods for allocating the central costs of an organization.
5.Use the direct, step-down, and reciprocal allocation methods to allocate service department costs to user departments.
6. Describe the general approach to allocating costs to products or services.
7. Use the physical units and relative-sales-value methods to allocate joint costs to products.
8. Use activity-based costing to allocate costs to products or services.
9.Identify the steps involved in the design and implementation of activity-based costing systems.
10.Calculate activity-based costs for cost objects.
A u n iversity’s com pu ter is u sed for teach in g an d for govern m en t-fu n ded research . How m u ch of its cost sh ou ld be assign ed to each task? A city creates a special police u n it to in vestigate a series of related assau lts. Wh at is th e total cost of th e effort? A com pan y u ses a m ach in e to m ake two differen t produ cts. How m u ch of th e cost of th e m ach in e belon gs to each produ ct? Th ese are all problem s of cost allocation , th e su bject of th is ch apter. Un iversity presiden ts, city m an -agers, corporate execu tives, an d oth ers all face problem s of cost allocation .
Th is is th e first of th ree ch apters on co st acco u n t in g sy st e m s—th e tech -n iqu es u sed to determ i-n e th e cost of a produ ct or service. A cost accou -n ti-n g sys-tem collects an d classifies costs an d assign s th em to cost objects. Th e goal of a cost accou n tin g system is to m easu re th e cost of design in g, developin g, produ cin g (or pu rch asin g), sellin g, distribu tin g, an d servicin g particu lar produ cts or services. Cost allocation is at th e h eart of m ost cost accou n tin g system s.
The first part of this chapter describes general approaches to cost allocation. Although we present some factors to consider in selecting cost-allocation methods, there are no easy answers. Recent attempts to improve cost-allocation methods have focused on activity-based costing, the subject of the last part of this chapter.
CO ST ALLO CATI O N I N GEN ERAL
As Ch apter 4 poin ted ou t, cost allocation is fu n dam en tally a problem of lin kin g (1) som e cost or grou ps of costs with (2) on e or m ore cost objectives, su ch as prod-u cts, departm en ts, an d division s. Ideally, costs sh oprod-u ld be assign ed to th e cost objective th at causedit. In sh ort, cost allocation tries to iden tify (1) with (2) via som e fu n ction represen tin g cau sation .
Lin kin g costs with cost objectives is accom plish ed by selectin g cost drivers. Wh en u sed for allocatin g costs, a cost driver is often called a co st-allo catio n base. Major costs, su ch as n ewsprin t for a n ewspaper an d direct profession al labou r for a law firm , m ay each be allocated to departm en ts, jobs, an d projects on an item byitem basis, u sin g obviou s cost drivers su ch as ton n es of n ewsprin t con -su m ed or direct-labou r-h ou rs u sed. Oth er costs, taken on e at a tim e, are n ot im portan t en ou gh to ju stify bein g allocated in dividu ally. Th ese costs are pooledan d th en allocated togeth er. A co st p o o lis a grou p of in dividu al costs th at is allocated to cost objectivesu sin g a sin gle cost driver. For exam ple, bu ildin g ren t, u tilities cost, an d jan itorial services m ay be in th e sam e cost pool becau se all are allocated on th e basis of squ are m etres of space occu pied. Or a u n iversity cou ld pool all th e operatin g costs of its registrar’s office an d allocate th em to its colleges on th e basis of th e n u m ber of stu den ts in each facu lty. In su m m ary, all costs in a given cost pool sh ou ld be cau sed by th e sam e factor. Th at factor is th e cost driver.
Man y differen t term s are u sed by com pan ies to describe cost allocation in practice. You m ay en cou n ter term s su ch as allocate, attribute, reallocate, trace, assign, distribute, redistribute, load, burden, apportion, an d reapportion, wh ich can be u sed in terch an geably to describe th e allocation of costs to cost objectives.
Three Purposes of Allocation
Managers within an organizational unit should be aware of all the consequences of their decisions, even consequences outside of their unit. Examples are the addition of a new course in a university that causes additional work in the registrar’s office,
th e addition of a n ew fligh t or an addition al passen ger on an airlin e th at requ ires reservation an d bookin g services, an d th e addition of a n ew specialty in a m ed-ical clin ic th at produ ces m ore work for th e m eded-ical records departm en t.
In each of th ese situ ation s, it is im portan t to assignto th e organ ization al u n it th e directin crem en tal costs of th e decision . Usin g th e distin ction n oted in Ch apter 4, m an agers assign direct costs with ou t u sin g allocated costs. Th e allocation of costs is n ecessary wh en th e lin kage between th e costs an d th e cost objective is in direct. In th is case, a basis for th e allocation , su ch as direct-labou r-h ou rs or ton n es of raw m aterial, is u sed even th ou gh its selection is arbitrary.
A cost allocation base has been described as incorrigible, since it is impossible to objectively determine which base perfectly describes the link between the cost and the cost objective. Given this subjectivity in the selection of a cost-allocation base, it has always been difficult for managers to determine “When should costs be allo-cated?” and “On what basis should costs be alloallo-cated?” The answers to these ques-tions depend on the principal purpose or purposes of the cost allocation.
Costs are allocated for th ree m ain pu rposes:
1. To obtain desired motivation. Cost allocation s are som etim es m ade to in flu en ce m an agem en t beh aviou r an d th u s prom ote goal con gru en ce an d m an agerial effort. Con sequ en tly, in som e organ ization s th ere is n o cost allocation for legal or in tern al au ditin g services or in tern al m an -agem en t con su ltin g services becau se top m an -agem en t w an ts to en cou rage th eir u se. In oth er organ ization s th ere is a cost allocation for su ch item s to spu r m an agers to m ake su re th e ben efits of th e specified services exceed th e costs.
2. To compute income and asset valuations. Costs are allocated to produ cts an d projects to m easu re in ven tory costs an d cost of goods sold. Th ese allo-cation s frequ en tly service fin an cial accou n tin g pu rposes. However, th e resu ltin g costs are also often u sed by m an agers in plan n in g, perfor-m an ce evalu ation , an d to perfor-m otivate perfor-m an agers, as described above. 3. To justify costs or obtain reimbursement. Som etim es prices are based
directly on costs, or it m ay be n ecessary to ju stify an accepted bid. For exam ple, govern m en t con tracts often specify a price th at in clu des reim bu rsem en t for costs plu s som e profit m argin . In th ese in stan ces, cost allocation s becom e su bstitu tes for th e u su al w orkin g of th e m ar-ketplace in settin g prices.
Th e first pu rpose specifies plan n in g an d con trol u ses for allocation . Th e sec-on d an d th ird sh ow h ow cost allocatisec-on s m ay differ for in ven tory costin g (an d cost of goods sold) an d for settin g prices. Moreover, differen t allocation s of costs to produ cts m ay be m ade for variou s pu rposes. Th u s, fu ll costs m ay gu ide pric-in g decision s, m an u factu rpric-in g costs m ay be appropriate for asset valu ation s, an d som e “in -between ” costs m ay be n egotiated for a govern m en t con tract.
Ideally, all three purposes would be served simultaneously by a single cost allo-cation. But thousands of managers and accountants will testify that for most costs, this ideal is rarely achieved. Instead, cost allocations are often a source of discontent and confusion for the affected parties. Allocating fixed costs usually causes the great-est problems. When all three purposes cannot be attained simultaneously, the man-ager and the accountant should start attacking a cost allocation problem by trying to identify which of the purposes should dominate in the particular situation at hand. Often inventory-costing purposes dominate by default because they are exter-nally imposed. When allocated costs are used in decision making and perform an ce
O BJECTI V E 1
evalu ation , m an agers sh ou ld con sider adju stin g th e allocation s u sed to satisfy in ven tory-costin g pu rposes. Often th e added ben efit of u sin g separate allocation s for plan n in g an d con trol an d in ven tory-costin g pu rposes is m u ch greater th an th e added cost.
Three Types of Allocations
As Exh ibit 5-1 sh ows, th ere are th ree basic types of cost allocation s:
1. Allocation of joint costs to the appropriate responsibility centres. Costs th at are u sed join tly by m ore th an on e u n it are allocated based on cost-driver activity in th e u n its. Exam ples are allocatin g ren t to departm en ts based on floor space occu pied, allocatin g am ortization on join tly u sed m ach in ery based on m ach in e-h ou rs, an d allocatin g gen eral adm in is-trative expen se based on total direct cost.
2. Reallocation of costs from one responsibility centre to another. Wh en on e u n it provides produ cts or services to an oth er, th e costs are tran sferred alon g with th e produ cts or services. Som e u n its, called se rv ice d e p art -m e n t s, exist on ly to su pport oth er departm en ts, an d th eir costs are totally reallocated. Exam ples in clu de person n el departm en ts, lau n dry departm en ts in h ospitals, an d legal departm en ts in in du strial firm s. 3. Allocation of costs of a particular organizational unit to its outputs of products
or services. Th e paediatrics departm en t of a m edical clin ic allocates its costs to patien t visits, th e assem bly departm en t of a m an u factu rin g firm to u n its assem bled, an d th e tax departm en t of a CA firm to clien ts served. Th e costs allocated to produ cts or services in clu de th ose allo-cated to th e organ ization al u n it in allocation types 1 an d 2.
All th ree types of allocation s are fu n dam en tally sim ilar. Let u s look first at h ow service departm en t costs are allocated to produ ction departm en ts.
Service D epartments.Units that exist only to serve other departments.
Cost accounting system accumulates costs
Allocation Type 1 Costs allocated to responsibility centres
Cost Objective 1 Responsibility centres
Allocation Type 2 Costs allocated from one responsibility centre to another
Cost Objective 2 Responsibility centres receiving products or services
Allocation Type 3
Costs allocated to products, jobs, or projects
Cost Objective 3 Products, jobs, or projects
EX H I B I T 5 - 1
ALLO CATI O N O F SERVI CE D EPARTM EN T CO STS
What causes costs? Organizations incur costs to produce goods and services and to provide the support services required for that production. Essentially, costs are caused by the very same activities that are usually chosen as cost objectives. Examples are products produced, patients seen, personnel records processed, and legal advice given. The ultimate effectsof these activities are various costs. It is impor-tant to understand how cost behaviour relates to activities and the consumption of resources. To perform activities, resources are required. These resources have costs. Some costs vary in direct proportion to the consumption of resources. Examples could be materials, labour, energy, and supplies. Other costs do not directly vary (in the short run) with resource usage. Examples of their indirect costs could be amor-tization, supervisory salaries, and rent. So we say that activities consume resources and the costs of these resources follow various behavioural patterns. Therefore, the manager and the accountant should search for some cost driver that establishes a convincing relationship between the cause (activity being performed) and the effect (consumption of resources and related costs) and that permits reliable predictionsof how costs will be affected by decisions regarding the activities.
To illu strate th is im portan t prin ciple, we will con sider allocation of service departm en t costs. Service departm en ts typically provide a service to a broad ran ge of fu n ction s an d produ cts with in an organ ization , an d th u s th e allocation of costs becom es m ore difficu lt. Th e preferred gu idelin es for allocatin g service departm en t costs are:
1. Evaluate performance using budgetsfor each service (staff) department, just as is done for each production or operating (line) department. The per-formance of a service department is evaluated by comparing actual costs with a budget, regardless of how the costs are later allocated. From the budget, variable-cost pools and fixed-cost pools can be identified.
2. Charge variable-and fixed-cost pools separately(som etim es called th e du al m eth od of allocation ). Note th at on e service departm en t (su ch as a com pu ter departm en t) can con tain m u ltiple cost pools if m ore th an on e cost driver cau ses th e departm en t’s costs. At a m in im u m , th ere sh ou ld be a variable-cost pool an d a fixed-cost pool.
3. Establish part of all of the details regarding cost allocation in advanceof ren -derin g th e service, rath er th an after th e fact. Th is approach establish es th e “ru les of th e gam e” so th at all departm en ts can plan appropriately. Con sider a sim plified exam ple of a com pu ter departm en t of a u n iversity th at serves two m ajor u sers: th e Sch ool of Bu sin ess an d th e Sch ool of En gin eerin g. Th e com pu ter m ain fram e was acqu ired on a five-year lease th at is n ot can cellable u n less proh ibitive cost pen alties are paid.
How sh ou ld costs be ch arged to th e u ser departm en ts? Su ppose th ere are two m ajor pu rposes for th e in form ation : (1) predictin g econ om ic effects of th e u se of th e com pu ter an d (2) m otivatin g departm en ts an d in dividu als to u se its capabilities m ore fu lly.
To apply th e first of th e above gu idelin es, we n eed to an alyze th e costs of th e com pu ter departm en t in detail. Th e prim ary activity perform ed is com pu ter processin g. Resou rces con su m ed in clu de processin g tim e, operator tim e, con su lt-in g tim e, en ergy, m aterials, an d bu ildlt-in g space. Su ppose cost beh aviou r an alysis h as been perform ed an d th e bu dget form u la for th e forth com in g fiscal year is $100,000 m on th ly fixed costs plu s $200 variable cost per h ou r of com pu ter tim e u sed. We will apply gu idelin es two an d th ree in th e n ext two section s.
O BJECTI V E 2
Explain the relationship between
C O M P A N Y
S T R A T E G I E S
Variable-Cost Pool
Th e cost driver for th e variable-cost pool is hours of computer time used. Th erefore, variable costs sh ou ld be assign ed as follows:
bu dgeted u n it rate ×actu al h ou rs of com pu ter tim e u sed
Th e cau se-an d-effect relation sh ip is direct an d clear: th e h eavier th e u sage, th e h igh er th e total costs. In th is exam ple, th e rate u sed wou ld be th e bu dgeted rate of $200 per h ou r.
The use of budgetedcost rates rather than actualcost rates for allocating variable costs of service departments protects the using departments from intervening price fluctuations and also often protects them from inefficiencies in the service depart-ments. When an organization allocates actualtotal service department cost, it holds user-department managers responsible for costs beyond their control and provides less in cen tive for service departm en ts to be efficien t. Both effects are u n desirable.
O BJECTI V E 3
Use recommended guidelines to charge the variable and fixed
costs of service departments to other organizational units.
CO ST ALLO CATIO N S AT BO REAL LABO RATO RIES LTD.
B
oreal is Canada’s largest supplier of science supplies and apparatus to Canadian schools. The product line is diverse and thus product costing is complex.A recent project included revisiting our inventory costing. In order to determine the inventory cost, many allocations have had to be made.
A combination of all the costing techniques listed in Chapter 13 have been used since there are several dif-ferent production departments and the production activities vary for each commodity.
In making allocations, three guidelines should be kept in mind.
1. The allocation must be fair.
2. The allocation must be rational and verifiable.
3. The impact on the people who use or work with this information must be known.
These guidelines provide a useful reference since there may be ramifications beyond just the immediate task or project, for which the initially intended allocation calculation was made.
Recently, the Inventory Costing System was revised to reflect current input costs and to reflect the change in operating costs and procedures as a result of moving to a new facility. When this inventory information was updated, the above three guidelines were considered when it came time to make allocations of costs.
This proved to be very beneficial since there have been many other applications of these calculations than those originally made for inventory purposes. Some of the additional uses of this information have been:
• Used to re-calculate selling prices in our catalogue to reflect the fact that our costs have changed. • Used to calculate a selling price on several special orders that involve different quantities and mixture of
products.
• Assisted in determining if Boreal would continue to produce a product in-house or to buy elsewhere. • Useful for accounting taxation purposes.
• A useful calculation in determining a profit-share amount since each department manager’s work is based upon performance.
Based upon the number and varying uses of an allocation, we can see how important allocations are in busi-ness. Furthermore, we should be aware that allocations may be used for more than one intended use.
Source: Written by John Richardson, Controller, Boreal Laboratories Ltd.
Con sider th e ch argin g of variablecosts to a departm en t th at u ses 600 h ou rs of com pu ter tim e. Su ppose in efficien cies in th e com pu ter departm en t cau sed th e variable costs to be $140,000 in stead of th e 600 h ou rs tim es $200, or $120,000 bu dgeted. A good cost-accou n tin g sch em e wou ld ch arge on ly th e $120,000 to th e con su m in g departm en ts an d wou ld let th e $20,000 rem ain as an u n favou rable bu dget varian ce of th e com pu ter departm en t. Th is sch em e h olds com pu ter departm en t m an agers respon sible for th e $20,000 varian ce an d redu ces th e resen tm en t of u ser m an agers. User-departm en t m an agers som etim es com plain m ore vigorou sly abou t u n certain ty over allocation s an d th e poor m an agem en t of a service departm en t th an abou t th e ch oice of a cost driver (su ch as direct-labou r dollars or n u m ber of em ployees). Su ch com plain ts are less likely if th e service departm en t m an agers h ave bu dget respon sibility an d th e u ser departm en ts are protected from sh ort-ru n price flu ctu ation s an d in efficien cies.
Most con su m ers prefer to kn ow th e total price in advan ce. Th ey becom e n ervou s wh en an au tom obile m ech an ic or con tractor u n dertakes a job with ou t specifyin g prices. As a m in im u m , th ey like to kn ow th e h ou rly rates th at th ey m u st bear. Th erefore, predeterm in ed u n it prices (at least) sh ou ld be u sed. Wh ere feasible, predeterm in ed total prices sh ou ld be u sed for variou s kin ds of work based on bu dgets an d stan dards.
To illu strate, con sider an au tom obile repair an d m ain ten an ce departm en t for a provin cial govern m en t. Agen cies wh o u se th e departm en t’s service sh ou ld receive firm prices for variou s services. Im agin e th e reaction of an agen cy m an -ager wh o h ad an agen cy au tom obile repaired an d was told, “Norm ally you r repair wou ld h ave taken five h ou rs, bu t we h ad a n ew em ployee work on it, an d th e job took ten h ou rs. Th erefore, we m u st ch arge you for ten h ou rs of labou r tim e.”
Fixed-Cost Pool
The cost driver for the fixed-cost pool is the amount of capacity required when the computer facilities were acquired. Therefore, fixed costs could be allocated as follows:
bu dgeted fraction of capacity available for u se ×total bu dgeted fixed costs
Con sider again ou r exam ple of th e u n iversity com pu ter departm en t. Su ppose th e dean h ad origin ally predicted th e followin g lon g-ru n average m on th ly u sage: Bu sin ess, 210 h ou rs, an d En gin eerin g, 490 h ou rs, for a total of 700 h ou rs. Th e fixed-cost pool wou ld be allocated as follows:
Th is predeterm in ed lu m p-su m approach is based on th e lon g-ru n capacity avail-ableto th e u ser, regardless of actu al u sage from m on th to m on th . Th e reason in g is th at th e level of fixed costs is affected by lon g-ran ge plan n in g regardin g th e overall level of service an d th e relative expectedu sage, n ot by short-runflu ctu ation s in service levels an d relative actualu sage.
A m ajor stren gth of u sin g capacity available rath er th an capacity u sed wh en allocatin g budgeted fixed costs is th at sh ort-ru n allocation s to u ser departm en ts
BU SIN ESS EN GIN EERIN G
Fixed costs per month:
210/700, or 30% of $100,000 $30,000
are n ot affected by th e actual u ser departm en ts. Su ch a bu dgeted lu m p-su m approach is m ore likely to h ave th e desired m otivation al effects with respect to th e orderin g of services in both th e sh ort ru n an d th e lon g ru n .
In practice, fixed-cost pools are often in appropriately allocated on th e basis of capacity u sed, n ot capacity available. Su ppose th e com pu ter departm en t allo-cated th e total actu al costs after th e fact. At th e en d of th e m on th , total actual wou ld be allocated in proportion to th e actual h ou rs u sed by th e con su m in g departm en ts. Com pare th e costs born e by th e two sch ools wh en Bu sin ess u ses 200 h ou rs an d En gin eerin g 400 h ou rs:
Wh at h appen s if Bu sin ess u ses on ly 100 h ou rs du rin g th e followin g m on th wh ile En gin eerin g still u ses 400 h ou rs?
En gin eerin g h as don e n oth in g differen tly, bu t it m u st bear h igh er costs of $13,333, an in crease of 9 percen t. Its sh ort-ru n costs depen d on w h at other con su m ers h ave u sed, n ot solely on its ow n action s. Th is ph en om en on is cau sed by a fau lty allocation m eth od for th e fixedportion of th e total costs, a m eth od w h ereby th e allocation s are h igh ly sen sitive to flu ctu ation s in th e actu al volu m es u sed by th e variou s con su m in g departm en ts. Th is w eakn ess is avoided by u sin g a predeterm in ed lu m p-su m allocation of fixed costs, based on bu dgeted u sage.
Con sider th e au tom obile repair sh op exam ple in trodu ced above. You w ou ld n ot be h appy if you cam e to get you r car an d w ere told, “Ou r daily fixed overh ead is $1,000. You rs w as th e on ly car in ou r sh op today, so w e are ch argin g you th e fu ll $1,000. If w e h ad processed 100 cars today, you r ch arge w ou ld h ave been on ly $10.”
Troubles with U sing Lump Sums
Th ere are problem s with u sin g lu m p-su m allocation s. If fixed costs are allocated on th e basis of lon gran ge plan s, th ere is a n atu ral ten den cy on th e part of con -su m ers to u n derestim ate th eir plan n ed u sage an d th u s obtain a sm aller fraction of th e cost allocation . Top m an agem en t can cou n teract th ese ten den cies by m on -itorin g prediction s an d by followin g u p an d u sin g feedback to keep fu tu re pre-diction s m ore h on est.
In som e organ ization s th ere are even rewards in th e form of salary in creases for m an agers wh o m ake accu rate prediction s. Moreover, som e cost-allocation m eth ods provide for pen alties for u n derprediction s. For exam ple, su p-pose a m an ager predicts u sage of 210 h ou rs an d th en dem an ds 300 h ou rs. Th e m an ager eith er doesn ’t get th e h ou rs or pays a price for every h ou r beyon d 210.
Total costs incurred, $100,000 + 600($200) = $220,000
Business: 200/600 x $220,000 = $ 73,333 Engineering: 400/600 x $220,000 = 146,667 Total cost allocated $220,000
Total costs incurred, $100,000 + 500(200) = $200,000
Allocating Central Costs
Th e n eed to allocate cen tral costs is a m an ifestation of a widespread, deep-seated belief th at all costs m u st som eh ow be fu lly allocated to th e reven u e-produ cin g (operatin g) parts of th e organ ization . Su ch allocation s are n eith er n ecessary from an accou n tin g viewpoin t n or u sefu l as m an agem en t in form ation . However, m ost m an agers accept th em as a fact of life—as lon g as all m an agers are treated alike. Wh en ever possible, th e preferred cost driver for cen tral services is u sage, eith er actu al or estim ated. Bu t th e costs of su ch services as pu blic relation s, top corporatem an agem en t overh ead, real estate departm en ts, an d corporateplan -n i-n g departm e-n ts are th e least likely to be allocated o-n th e basis of u sage. Data processin g, advertisin g, an d operation s research are th e m ost likely to ch oose u sage as a cost driver.
Com pan ies th at allocate cen tral costs by u sage ten d to gen erate less resen t-ment. Consider the experience of J.C. Penney Co. as reported in Business Week:
Th e con troller’s office wan ted su bsidiaries su ch as Th rift Dru g Co. an d th e in su ran ce operation s to base th eir sh are of corporate person n el, legal, an d au ditin g costs on th eir reven u es. Th e su bsidiaries con ten ded th at th ey m ain tain ed th eir own person n el an d legal departm en ts, an d sh ou ld be assessed far less.
Th e su bcom m ittee addressed th e issu e by askin g th e corporate departm en ts to approxim ate th e tim e an d costs in volved in servicin g th e su bsidiaries. Th e fin al allocation plan , based on th ese stu dies, cost th e division s less th an th ey were in itially assessed bu t m ore th an th ey h ad wan ted to pay. Non eth eless, th e plan was im plem en ted easily.
Usage is not always an economically viable way to allocate central costs, however. Also, many central costs, such as the president’s salary and related expenses, public relations, legal services, income tax planning, company-wide advertising, and basic research, are difficult to allocate on the basis of cause and effect. As a result, some companies use cost drivers such as the revenue of each division, the cost of goods sold by each division, the total assets of each division, or the total costs of each divi-sion (before allocation of the central costs) to allocate central costs.
Th e u se of th e foregoin g cost drivers m igh t provide a rough in dication of cau se-an d-effect relation sh ip. Basically, h owever, th ey represen t an “ability to bear” ph ilosoph y of cost allocation . For exam ple, th e costs of com pan y-wide advertisin g, su ch as th e goodwill spon sorsh ip of a program on a n on -com m ercial television station , m igh t be allocated to all produ cts an d division s on th e basis of th e dollar sales in each . Bu t su ch costs precede sales. Th ey are discretion ary costs as determ in ed by m an agem en t policies, n ot by sales resu lts. Alth ou gh 60 percen t of th e com pan ies in a large su rvey treat sales reven u e as a cost driver for cost allocation pu rposes, it is n ot tru ly a cost driver in th e sen se of bein g an activity th at causesth e costs.
If th e costs of cen tral services are to be allocated based on sales even th ou gh th e costs do n ot vary in proportion to sales, th e u se of budgetedsales is preferable to th e u se of actualsales. At least th is m eth od m ean s th at th e sh ort-ru n costs of a given con su m in g departm en t will n ot be affected by th e fortu n es of oth er con -su m in g departm en ts.
For exam ple, su ppose $100 of fixed cen tral advertisin g costs were allocated on th e basis of poten tial sales in two territories:
O BJECTI V E 4
Identify methods for allocating the central costs of an
organization.
J.C. Penney www.jcpenney.com
Con sider th e possible differen ces in allocation s wh en actu al sales becom e kn own :
Com pare allocation 1 with 2. Allocation 1 is preferable. It in dicates a low ratio of sales to advertisin g in territory A. It directs atten tion wh ere it is deserved. In con -trast, allocation 2 soaks territory B with m ore advertisin g cost becau se of th e achievedresu lts an d relieves territory A despite its lower su ccess. Th is is an oth er exam ple of th e an alytical con fu sion th at can arise wh en cost allocation s to on e con su m in g departm en t depen d on th e activity of oth er con su m in g departm en ts.
Reciprocal Services
Service departments often support other service departments as well as supporting producing departments. Consider a manufacturing company with two producing departments—moulding and finishing—and two service departments, facilities management (rent, heat, light, janitorial services, etc.) and personnel. All costs in a given service department are assumed to be caused by, and therefore vary in pro-portion to, a single cost driver. The company has decided that the best cost driver for facilities management costs is square metres occupied and the best cost drivers for personnel is the number of employees. Exhibit 5-2 shows the direct costs, square metres occupied, and number of employees for each department. Note that facilities management provides services for the personnel department in addition to provid-ing services for the producprovid-ing departments, and that personnel aids employees in facilities management as well as those in production departments.
Budgeted sales $500 $500 $1,000 100%
Central advertising $ 50 $ 50 $ 100 10% allocated
TERRITO RIES
A B TOTAL PERCEN T
Actual Sales $300 $600
Central advertising:
1. Allocated on basis of budgeted sales $ 50 $ 50 or
2. Allocated on basis of actual sales $ 33 $ 67
TERRITO RIES
A B
EX H I B I T 5 - 2
Cost Drivers
SERVICE PRO D U CTIO N
D EPARTM EN TS D EPARTM EN TS
FACILITIES
M ANAGEM EN T PERSO N N EL M O U LD IN G FIN ISH IN G
Direct department costs $126,000 $24,000 $100,000 $160,000
Square metres 3,000 9,000 15,000 3,000
Number of employees 20 30 80 320
Direct labour hours 2,100 10,000
1How sh ou ld we determ in e wh ich of th e two service departm en ts provides th e m ost service
to th e oth er? On e way is to carry ou t step on e of th e step-down m eth od with facilities m an agem en t allocated first, an d th en repeat it assu m in g person n el is allocated first. With facilities m an agem en t allocated first, $42,000 is allocated to person n el, as sh own in Exh ibit 5-3. If person n el h ad been allo-cated first, (20/ 420) ×$24,000 = $1,143 wou ld h ave been allocated to facilities m an agem en t. Becau se $1,143 is sm aller th an $42,000, facilities m an agem en t is allocated first.
Step-D own M ethod.
Th ere are th ree popu lar m eth ods for allocatin g service departm en t costs in su ch cases: th e direct m eth od, th e step-down m eth od, an d th e reciprocal alloca-tion m eth od.
D irect M ethod
As its n am e im plies, th e d ire ct m e t h o d ign ores oth er service departm en ts wh en an y given service departm en t’s costs are allocated to th e reven u e-produ cin g (operatin g) departm en ts. In oth er words, th e fact th at facilities m an agem en t pro-vides services for person n el is ign ored, as is th e su pport th at person n el propro-vides to facilities m an agem en t. Facilities m an agem en t costs are allocated based on th e relative squ are m etres occupied by the production departments only:
• Total squ are m etres in produ ction departm en ts: 15,000 + 3,000 = 18,000
• Facilities management cost allocated to moulding = (15,000 ÷18,000) ×$126,000 = $105,000
• Facilities m an agem en t cost allocated to fin ish in g = (3,000 ÷18,000) ×$126,000 = $21,000
Likewise, personnel department costs are allocated only to the production departments on the basis of the relative number of employees in the production departments:
• Total employees in production departments = 80 + 320 = 400
• Person n el costs allocated to m ou ldin g = (80 ÷400) ×$24,000 = $4,800
• Personnel costs allocated to finishing = (320 ÷400) ×$24,000 = $19,200
Step-D own M ethod
Th e st e p -d o w n m e t h o d recogn izes th at som e service departm en ts su pport th e activities in oth er service departm en ts as well as th ose in produ ction depart-m en ts. A sequ en ce of allocation s is ch osen , u su ally by startin g with th e service departm en t th at ren ders th e greatest service (as m easu red by costs) to th e great-est n u m ber of oth er service departm en ts. Th e last service departm en t in th e sequ en ce is th e on e th at ren ders th e least service to th e least n u m ber of oth er service departm en ts. On ce a departm en t’s costs are allocated to oth er depart-m en ts, n o su bsequ en t service departdepart-m en t costs are allocated back to it.
In ou r exam ple, facilities m an agem en t costs are allocated first. Wh y? Becau se facilities m an agem en t ren ders m ore su pport to person n el th an person -n el provides for facilities m a-n agem e-n t.1 Exam in e Exh ibit 5-3. After facilities
M O U LD IN G FIN ISH IN G
D IRECT STEP-D OW N RECIPRO CAL D IRECT STEP-D OW N RECIPRO CAL
Direct department costs $100,000 $100,000 $100,000 $160,000 $160,000 $160,000 Allocated from facilities management 105,000 70,000 71,789 21,000 14,000 14,358 Allocated from personnel 4,800 13,200 12,768 19,200 52,800 51,070 Total costs $209,800 $183,200 $184,557 $200,200 $226,800 $225,428 EX H I B I T 5 - 3
Step-Down Allocation
FACILITIES
M ANAGEM EN T PERSO N N EL M O U LD IN G FIN ISH IN G TOTAL
Direct department costs
before allocation $126,000 $24,000 $100,000 $160,000 $410,000 Step 1:
Facilities management $(126,000) (9 ÷ 27) (15 ÷ 27) (3 ÷ 27) 0 x $126,000 x $126,000 x $126,000
= $42,000 = $70,000 = $14,000 Step 2:
Personnel $(66,000) (80 ÷ 400) (320 ÷ 400) 0
x $66,000 x $66,000 = $13,200 = $52,800
Total cost after allocation $ 0 $ 0 $183,200 $226,800 $410,000
EX H I B I T 5 - 5
Direct versus Step-Down Method
EX H I B I T 5 - 4
Reciprocal Allocation Method
FACILITIES
M ANAGEM EN T PERSO N N EL M O U LD IN G FIN ISH IN G TOTAL
Direct department costs
before allocation $126,000 $24,000 $100,000 $160,000 $410,000
Allocation of facilities $(129,220) (9 ÷ 27) (15 ÷ 27) (3 ÷ 27) 0 management x $129,220 x $129,220 x $129,220
= $43,073 = $71,789 = $14,358
Allocation of personnel (20 ÷ 420) $(67,030) (80 ÷ 450) (320 ÷ 450) 0 x $67,030 x $67,030 x $67,030
= $3,192 = $12,768 = $51,070
Total cost after allocation $(28)* $ 43* $184,557 $225,428 $410,000
Exam in e th e last colu m n of Exh ibit 5-3. Before allocation , th e fou r depart-m en ts in cu rred costs of $410,000. In step 1, $126,000 was dedu cted frodepart-m facili-ties m an agem en t an d added to th e oth er th ree departm en ts. Th ere was n o n et effect on th e total cost. In step 2, $66,000 was dedu cted from person n el an d added to th e rem ain in g two departm en ts. Again , total cost was u n affected. After allocation , all $410,000 rem ain s, bu t it is all in m ou ldin g an d fin ish in g. Non e was left in facilities m an agem en t or person n el.
Reciprocal Allocation M ethod
Th e re cip ro cal allo cat io n m e t h o d allocates costs by recogn izin g th at th e ser-vice departm en ts provide serser-vices to each oth er as well as to th e produ ction departm en ts. Th is m eth od is gen erally viewed as bein g th e m ost th eoretically correct as it en ables u s to cost th e in terdepartm en tal relation sh ips fu lly in to th e service departm en t cost allocation s. In ou r exam ple, th e facilities m an agem en t cost is allocated to th e person n el departm en t an d th e person n el cost is allocated to th e facilities m an agem en t departm en t before th e costs of th e service depart-m en ts are allocated to th e produ ction departdepart-m en ts.
First, we m u st allocate th e costs of th e services provided between th e two service departm en ts. We do th is u sin g th e followin g two equ ation s in wh ich th e facilities m an agem en t costs are defin ed as FM an d th e person n el costs as P.
FM = $126,000 + 20/ 420 P = $126,000 + .048 P P = $24,000 + 9/ 27 FM = $24,000 + .333 FM
Th en we solve th e two sim u ltan eou s equ ation s to determ in e th e total am ou n t of costs for each service departm en t.
FM = $126,000 + (.048 [$24,000 + .333 FM]) FM = $126,000 + $1,152 + .016 FM
.984 FM = $127,152 FM = $129,220
P = $24,000 + .333 ($129,220) P = $24,000 + $43,030
P = $67,030
Th u s, th e total costs to be allocated for facilities m an agem en t is $129,220 an d for person n el is $67,030. Exh ibit 5-4 provides th e details of th e allocation s of th e costs for th ese two service departm en ts to th e two produ ction departm en t. Note th at th e total of th e costs allocated is still $410,000 (after m in or adju stm en ts du e to rou n din g errors).
Com pare th e costs of th e produ ction departm en ts u n der direct, step-down an d reciprocal allocation m eth ods as sh own in Exh ibit 5-5.
Note th at th e m eth od of allocation can greatly affect th e costs. Mou ldin g appears to be a m u ch m ore expen sive operation to a m an ager u sin g th e direct m eth od th an to on e u sin g th e step-dow n or reciprocal allocation m eth od. Con versely, fin ish in g seem s m ore expen sive to a m an ager u sin g th e n on -direct m eth od.
Which method is better? It is sometimes difficult to say. An advantage of the step-down method is that it recognizes the effects of the most significant support provided by service departments to other service departments. In our example, the direct method does not make any assumptions about the following possible cause-effect link: if the cost of facilities management is caused by the space used, then the space used by personnel causes $42,000 of facilities man agem en t costs. If th e space u sed in person n el is cau sed by th e n u m ber of produ ction -departm en t em ployees su pported, th en th e n u m ber of produ ction -departm en t em ployees, n ot th e squ are m etres, cau ses $42,000 of th e facilities m an agem en t cost. Th e produ cin g departm en t with th e m ost em ployees, n ot th e on e with th e m ost squ are m etres, sh ou ld bear th is cost.
Th e greatest virtu e of th e direct m eth od is its sim plicity. If th e th ree m eth -ods do n ot produ ce sign ifican tly differen t resu lts, m an y com pan ies opt for th e direct m eth od becau se it is easier for m an agers to u n derstan d.
ALLO CATI N G CO STS TO O U TPU TS
Up to th is poin t, we h ave con cen trated on cost allocation to division s, depart-m en ts, an d sidepart-m ilar segdepart-m en ts of a codepart-m pan y. Cost allocation is often carried on e step fu rth er—to th e ou tpu ts of th ese departm en ts, h owever defin ed. Exam ples are products, su ch as au tom obiles, fu rn itu re, an d n ewspapers, an d services, su ch as ban kin g, h ealth care, an d edu cation . Som etim es th e allocation of total depart-m en tal costs to th e reven u e-produ cin g produ cts or services is called co st ap p li-cat io nor cost attribution.
General Approach
Th e gen eral approach to allocatin g costs to fin al produ cts or services is as follows:
1. Allocate production-related costs to the operating (line), production, or revenue-producing departments. This includes allocating service depart-ment costs to the production departdepart-ments following the guidelines listed on page 182. The production departments then contain all the costs: their direct department costs and the service department costs.
2. Select on e or m ore cost drivers in each produ ction departm en t. Historically, most companies have used only one cost driver per depart-ment. Recently, a large number of companies have started using multiple costs pools and multiple cost drivers within a department. For example, a portion of the departmental costs may be allocated on the basis of direct-labour hours, another portion on the basis of machine hours, and the remainder on the basis of the number of machine setups.
3. Allocate (assign ) th e total costs accu m u lated in step 1 to produ cts or services th at are th e ou tpu ts of th e operatin g departm en ts u sin g th e cost drivers specified in step 2. If on ly on e cost driver is u sed, two cost pools sh ou ld be m ain tain ed, on e for variable costs an d on e for fixed costs. Variable costs sh ou ld be assign ed on th e basis of actu al cost dri-ver activity. Fixed costs sh ou ld eith er rem ain u n allocated or be allo-cated on th e basis of bu dgeted cost driver activity.
O BJECTI V E 6
Describe the general approach to allocating
costs to products or services. Cost Application.The
Con sider ou r m an u factu rin g exam ple, an d assu m e th at th e step-down m eth od was u sed to allocate service departm en t costs. Exh ibit 5-3 sh ows total costs of $183,200 accu m u lated in m ou ldin g an d $226,800 in fin ish in g. Note th at all $410,000 total m an u factu rin g costs reside in th e produ ction departm en ts. To allocate th ese costs to th e produ cts produ ced, cost drivers m u st be selected for each departm en t. We will u se a sin gle cost driver for each departm en t an d assu m e th at all costs are cau sed by th at cost driver. Su ppose m ach in e h ou rs is th e best m easu re of wh at cau ses costs in th e m ou ldin g departm en t, an d direct-labou r h ou rs m easu res cau sation in fin ish in g. Exh ibit 5-2 sh owed 30,000 total m ach in e-h ou rs u sed in m ou ldin g an d 10,000 direct labou r e-h ou rs in fin ise-h in g. Te-h erefore, costs are allocated to produ cts as follows:
Mou ldin g: $183,200 ÷30,000 m ach in e-h ou rs = $6.11 per m ach in e-h ou r terday on the issue of how monthly phone rates break down.
Th e Can adian Radio-television an d Telecommunications Commission will hold hearings in May on the so-called “split rate base” — the separation of a phone com-pany’s costs for long-distance competitive services from local monopoly services.
Com petitors ch arge th at Bell an d oth -ers m isallocate costs of providin g com pet-itive services to th e m on opoly costs. Th at allows for lower lon g-distan ce rates an d h u rts rival com pan ies th at h ave to beat th ose prices, drivin g u p th e su bsidy com -petitors pay to th e local bu sin ess.
Both sides will be offering their versions
It fou n d Bell’s costs were 2.8¢ lower per m in u te th an U.S. gian t AT&T. Th e dif-feren ce was attribu ted to AT&T’s h igh er m arketin g an d cu stom er service costs, an d h igh er corporate operation s.
Un itel said th at u sin g CRTC Ph ase III accou n tin g m eth ods, lon g-distan ce costs for U.S. carriers are 12.3¢ per m in u te, wh ile costs for Can adian carriers average abou t 8.1¢ — a 52 percen t differen ce.
On e of th e problem s is th at teleph on e com pan ies often m ake u se of th e sam e person n el an d equ ipm en t for both local an d lon g-distan ce bu sin ess. Un itel cites cu stom er billin g as an exam ple of wh en both m on opoly an d com petitive services are ch arged on th e sam e bill, join tly in cu rrin g th e costs.
ALLO CATI N G JO I N T CO STS AN D BY-PRO D U CT CO STS
Join t costs an d by-produ ct costs create especially difficu lt cost allocation prob-lem s. By defin ition , su ch costs relate to m ore th an on e produ ct bu t can n ot be separately iden tified with an in dividu al produ ct.
Joint Costs
So far we h ave assu m ed th at cost drivers cou ld be iden tified with an in dividu al produ ct. For exam ple, if costs are bein g allocated to produ cts or services on th e basis of m ach in e h ou rs, we h ave assu m ed th at each m ach in e h ou r is u sed on a sin gle fin al produ ct or service. However, som etim es in pu ts are added to th e pro-du ction process before in divipro-du al propro-du cts are separately iden tifiable (th at is, before th e split-off point). Su ch costs are called jo in t co st s. Join t costs in clu de all in pu ts of m aterial, labou r, an d overh ead costs th at are in cu rred before th e split-off poin t.
Su ppose a departm en t h as m ore th an on e produ ct an d som e costs are join t costs. How sh ou ld su ch join t costs be allocated to th e produ cts? Allocation of join t costs sh ou ld n ot affect decision s abou t th e in dividu al produ cts. Neverth eless, join t produ ct costs are rou tin ely allocated to produ cts for pu rposes of inventory valuation an d income determination.
Assu m e a departm en t in Dow Ch em ical Com pan y produ ces two ch em icals, X an d Y. Th e join t cost is $100,000, an d produ ction is 1,000,000 litres of X an d 500,000 litres of Y. Produ ct X can be sold for $.09 per litre an d Y for $.06 per litre. Ordin arily, som e part of th e $100,000 join t cost will be allocated to th e in ven tory of X an d th e rest to th e in ven tory of Y. Su ch allocation s are u sefu l for in ven tory pu rposes on ly. Join t cost allocation s sh ou ld be ign ored for decision s su ch as sell-in g a josell-in t produ ct or processsell-in g it fu rth er.
Two con ven tion al ways of allocatin g join t costs to produ cts are widely u sed: physical unitsan d relative sales values. If ph ysical u n its were u sed, th e join t costs wou ld be allocated as follows:
Th is approach sh ows th at th e $33,333 join t cost of produ cin g Y exceeds its $30,000 sales valu e at split-off, wh ich seem s to in dicate th at Y sh ou ld n ot be pro-du ced. However, su ch an allocation is n ot h elpfu l in m akin g propro-du ction deci-sion s. Neith er of th e two produ cts cou ld be produ ced separately.
A decision to produ ce Y m u st be a decision to produ ce X and Y. Becau se total reven u e of $120,000 exceeds th e total join t cost of $100,000, both will be produ ced. Th e allocation was n ot u sefu l for th is decision .
Th e ph ysical u n its m eth od requ ires a com m on ph ysical u n it for m easu rin g th e ou tpu t of each produ ct. For exam ple, board feet is a com m on u n it for a
O BJECTI V E 7
Use the physical units and relative-sales-value methods to allocate joint costs to products.
D ow Chemical www.dow.com
Joint Costs.Costs of inputs added to a process before individual products are separated.
ALLO CATIO N O F SALES VALU E AT LITRES W EIGH TIN G JO IN T CO STS SPLIT-O FF
X 1,000,000 10/15 x $100,000 $ 66,667 $ 90,000 Y 500,000 5/15 x $100,000 33,333 30,000
variety of produ cts in th e lu m ber in du stry. However, som etim es su ch a com m on den om in ator is lackin g. Con sider th e produ ction of m eat an d h ides from bu tch erin g a steer. You m igh t u se kilogram s as a com m on den om in ator, bu t kilogram s is n ot a good m easu re of th e ou tpu t of h ides. As an altern ative, m an y com -pan ies u se th e relative sales value methodfor allocatin g join t costs. Th e followin g allocation resu lts from applyin g th e relative sales valu e m eth od to th e Dow Ch em ical departm en t:
Th e weigh tin g is based on th e sales valu es of th e in dividu al produ cts. Becau se th e sales valu e of X at split-off is $90,000 an d total sales valu e at split-off is $120,000, X is allocated 90/ 120 of th e join t cost.
Now each produ ct wou ld be assign ed a join t cost portion th at is less th an its sales valu e at split-off. Note h ow th e allocation of a cost to a particu lar produ ct su ch as Y depen ds n ot on ly on th e sales valu e of Y bu t also on th e sales valu e of X. For exam ple, su ppose you were th e produ ct m an ager for Y. You plan n ed to sell you r 500,000 litres for $30,000, ach ievin g a profit of $30,000 – $25,000 = $5,000. Everyth in g wen t as expected except th at th e price of X fell to $.07 per litre for reven u e of $70,000 rath er th an $90,000. In stead of 30/ 120 of th e join t cost, Y received 30/ 100 ×$100,000 = $30,000 an d h ad a profit of $0. Despite th e fact th at Y operation s were exactly as plan n ed, th e cost-allocation m eth od cau sed th e profit on Y to be $5,000 below plan .
Th e relative sales valu e m eth od can also be u sed wh en on e or m ore of th e join t produ cts can n ot be sold at th e split-off poin t. To apply th e m eth od, we approxim ate th e sales valu e at split-off as follows:
sales valu e at split-off = fin al sales valu e – separate costs
For exam ple, su ppose th e 500,000 litres of Y requ ires $20,000 of processin g beyon d th e split-off poin t, after wh ich it can be sold for $.10 per litre. Th e sales valu e at split-off wou ld be $.10 × 500,000 – $20,000 = $50,000 – $20,000 = $30,000.
By-Product Costs
By-produ cts are sim ilar to join t produ cts. A by -p ro d u ct is a produ ct th at, like a join t produ ct, is n ot in dividu ally iden tifiable u n til m an u factu rin g reach es a split-off poin t. By-produ cts differ from join t produ cts becau se th ey h ave relatively in sign ifican t total sales valu e in com parison with th e oth er produ cts em ergin g at split-off. Join t produ cts h ave relatively sign ifican t total sales valu es at split-off in com parison with th e oth er join tly produ ced item s. Exam ples of by-produ cts are glycerin e from soap-m akin g an d m ill en ds of cloth an d carpets.
RELATIVE SALES
VALU E AT ALLO CATIO N O F
SPLIT-O FF W EIGH TIN G JO IN T CO STS
X $ 90,000 90/120 x $100,000 $ 75,000 Y 30,000 30/120 x $100,000 25,000
$120,000 $100,000
C O M P A N Y
S T R A T E G I E S
J.M . Schneider www.jmschneider.com
If an item is accou n ted for as a by-produ ct, on ly separable costs are assign ed to it. All join t costs are allocated to m ain produ cts. An y reven u es from by-prod-u cts, less th eir separable costs, are dedby-prod-u cted from th e cost of th e m ain prodby-prod-u cts. Con sider a lu m ber com pan y th at sells sawdu st gen erated in th e produ ction of lu m ber to com pan ies m akin g particle board. Su ppose th e com pan y regards th e sawdu st as a by-produ ct. In 2001, sales of sawdu st totalled $30,000, an d th e cost of loadin g an d sh ippin g th e sawdu st (th at is, costs in cu rred beyon d th e split-off poin t) was $20,000. Th e in ven tory cost of th e sawdu st wou ld con sist of on ly th e $20,000 separable cost. Non e of th e join t cost of produ cin g lu m ber an d sawdu st wou ld be allocated to th e sawdu st. Th e differen ce between th e reven u e an d sep-arable cost, $30,000 – $20,000 = $10,000, wou ld be dedu cted from th e cost of th e lu m ber produ ced.
ACTI VI TY-BASED CO STI N G (ABC)
In th e past, th e vast m ajority of departm en ts u sed direct labou r h ou rs as th e on ly cost driver for applyin g costs to produ cts. Bu t direct labou r h ou rs is n ot a very good m easu re of th e cau se of costs in m odern , h igh ly au tom ated departm en ts. Labou r-related costs in an au tom ated system m ay be on ly 5 percen t to 10 per-cen t of th e total m an u factu rin g costs an d often are n ot related to th e cau ses of m ost m an u factu rin g overh ead costs. Th erefore, m an y com pan ies are begin n in g to u se m ach in e-h ou rs as th eir cost-allocation base. However, som e m an agers in m odern m an u factu rin g firm s an d au tom ated service com pan ies believe it is in ap-propriate to allocate all costs based on m easu res of volu m e. Usin g direct labou r h ou rs or cost—or even m ach in e h ou rs—as th e on ly cost driver seldom m eets th e cau se/ effect criterion desired in cost allocation . If m an y costs are cau sed by n on -volu m e-based cost drivers, A ctivity-Base d Co stin g (A BC)sh ou ld be con sidered.
ACTIVITY-BASED CO STIN G AT J. M . SCH N EID ER IN C.
S
chneider Corporation is one of Canada’s largest producers of premium-quality food products. The company’s mission statement, which provides a common focus to all activities within the corporation, is:To generate profitable growth by providing high-quality food products of superior value in specific market seg-ments while maintaining our status as a financially secure, well-managed, ethical company.
The majority of the Corporation’s meat processing is done through its subsidiary, J. M. Schneider Inc. In the late 1980s the Canadian meat-packing industry, in which the company’s core business operated, was in critical condition. Red meat consumption levels were declining at an alarming rate, as consumers adopted chang-ing lifestyles and eatchang-ing habits. Meat producers and food retailers rationalized into a handful of participants engaged in intense price competition. This development resulted in a sharp decline in profitability for Schneider.
In the absence of significant market growth opportunities, Schneider launched an initiative to internally gen-erate efficiencies and cost reductions in order to improve profit margins. The vehicle chosen to drive these improvements was the implementation of a broadly based continuous improvement program.2
This program, in order to be successful, required the support of a more up-to-date and relevant cost system. Up until this time, Schneider had used a standard cost system to meet the requirements of measuring the suc-cess of its labour and materials yield productivity program. This program measured productivity gains by com-paring actual results to costs in the standard cost system.3
O BJECTI V E 8
Use activity-based costing to allocate costs
C O M P A N Y
S T R A T E G I E S
Continued
There were a number of shortcomings with the company’s conventional standard cost system, however: 1. The focus was on minimizing costs within each department. Consequently, actions would be taken in one
department that would reduce their costs, but would create additional costs in downstream departments. 2. Targets were limited to material yield and direct labour productivity. Opportunities to better control and
manage a number of other manufacturing costs and overheads were not measured.
3. Comparisons were made to standards that incorporated allowances for waste and non-value-added activ-ity. Although meeting the standard costs satisfied management, it resulted in “ satisfactory” costs rather than “ minimum” costs.
Schneider realized that the primary emphasis of its cost system should be to provide relevant and reliable information for management decision making rather than focusing only on financial reporting requirements.
Under continuous improvement, the focus on minimizing costs broadened from control of yields and direct labour productivity to better understanding and managing the entire business cycle. Continuous improvement ini-tiatives were launched to address just-in-time, productive maintenance, total quality control, quick changeover tech-niques, cycle time, identification and elimination of non-value-added activities. The standard cost system was unable to accurately measure and report the true costs of these activities, and was in need of an overhaul.
In order to better measure and, in turn, understand production cost behaviour, Schneider decided to implement Activity-Based Costing (ABC). ABC systems are designed on the premise that products require “ activities” and that these activities, in turn, consume “ resources,” i.e., incur costs. Non-value- added activities and waste are more clearly highlighted and therefore better managed. Non-financial measures have also been recognized as key yardsticks in measuring operational performance (i.e., tonnage throughput, machine downtime hours, process cycle time, etc.).
The information generated by this updated management accounting system will be supportive of the firm’s con-tinuous improvement and cost reduction programs, providing relevant and reliable decision-making information.
2Dodds, Douglas W., “ MAKING IT BETTER....and better,” CMA MAGAZINE, February 1992, pp. 16–21. 3For a more complete discussion of the standard cost system, see Armitage, H.M., and A. A. Atkinson, “ The Choice of Productivity Measures in Organizations: A Field Study of Practice in Seven Canadian Firms.” Society of Management Accountants of Canada, Hamilton, Ontario, 1990.
Source:Written by John Carney, Manager Accounting Services and Larry Wozniak, Senior Cost Analyst, J. M. Schneider Inc.
Activity-Based Costing
A ct iv it y -base d co st in g (A BC)system s first accu m u late overh ead costs for each of th e activities of an organ ization , an d th en assign th e costs of activities to th e produ cts, services, or oth er cost objects th at cau sed th at activity. To establish a cau se-effect relation sh ip between an activity an d a cost object, cost drivers are iden tified for each activity. Con sider th e followin g activities an d cost driversfor th e Belm on t m an u factu rin g plan t departm en t of a m ajor applian ce produ cer:
A CTIVITY COST D RIVER
Produ ction set-u p Nu m ber of produ ction ru n s
Produ ction con trol Nu m ber of produ ction process ch an ges En gin eerin g Nu m ber of en gin eerin g ch an ge orders Main ten an ce Nu m ber of m ach in e h ou rs
Power Nu m ber of kilowatt h ou rs
CM A M agazine
www.cma-canada.org
Most organ ization s are n ow realizin g th at to su cceed th ey m u st focu s on a few core com peten cies, th in gs th ey u n iqu ely do very w ell. For exam ple, Com paq defin es itself as a “platform in tegrator” developin g an d m arketin g produ cts wh ose com pon en ts are largely m an u fac-tu red by oth ers. Su ch organ ization s real-ize th at th ey sh ou ld n ot seek to do activities for wh ich th ey do n ot h ave com petitive advan tage.
Tradition ally, ou tsou rcin g started with n arrow, low-risk activities su ch as payroll processin g, data cen tre m an agem en t, an d caterin g. Now m u ch m ore strategic activ-ities are startin g to be ou tsou rced, in clu d-in g fd-in an cial m an agem en t, h u m an resou rce m an agem en t, su pply ch ain m an agem en t an d even cu stom er m an -agem en t processes. Also, th e scope of th e ou tsou rcin g relation sh ips is m u ch broader; for exam ple, ou tsou rcin g of accou n tin g u sed to con sist prim arily of accou n ts receivable collection an d pay-roll. Now, organ ization s are ou tsou rcin g th eir en tire fin an cial tran saction process-in g, recogn izprocess-in g th at th eir own com pe-possible, an d n ecessary, for organ ization s to im plem en t n ew bu sin ess m odels, with exten sive ou tsou rcin g of processes to th ird parties. Organ ization s su ch as Cisco h ave dem on strated th at th ey can dom i-qu ite dram atically over th e n ext few years towards a n ew relation sh ip ch arac-terized by th e followin g factors:
• a broaden in g of th e scope of ou t-sou rcin g relation sh ips;
• sign ifican t in vestm en t by th e service provider, particu larly in in form ation tech n ology in frastru ctu re to su pport service delivery;
• u se of e-bu sin ess to im plem en t n ew an d h igh ly in n ovative ou tsou rcin g relation sh ips; an d
• sh arin g of risks an d rewards associ-ated with th e ou tsou rcin g.
Th e ou tsou rcin g m arket m ove towards h igh ly strategic partn erin g arran gem en ts addresses su ch broad processes as: fin an -cial tran saction processin g; h u m an resou rce adm in istration ; su pply ch ain m an agem en t; docu m en t an d prin t m an -agem en t; an d cu stom er service.
Several of th e m ost progressive global organ ization s will seek ou tsou rcin g part-n ersh ips th at focu s opart-n epart-n h apart-n cipart-n g sh are-pan ies, in clu din g 26 large Can adian organ ization s. Th e research , con du cted by an in depen den t m arket research organ ization , h igh ligh ted som e in terest-in g issu es an d tren ds am on gst th e Can adian participan ts.
• Seventy-three percent of the organi-zations have outsourced at least one activity or process. The main rea-sons for outsourcing are: to enable a focus on core competencies; enhance ben efits adm in istration payroll pro cessin g; logistics; real estate m an agem en t, an d in tern al au dits.
Cost-driver activity is m easu red by th e n u m ber of tran saction s in volved in th e activity. For exam ple, in th is case, en gin eerin g costs are cau sed by ch an ge orders (a docu m en t detailin g a produ ction ch an ge th at requ ires th e atten tion of th e en gin eerin g departm en t). Th erefore, en gin eerin g costs are assign ed to prod-u cts in proportion to th e n prod-u m ber of en gin eerin g ch an ge orders issprod-u ed for each produ ct. If th e produ ction of m icrowave oven s cau sed 18 percen t of th e en gi-n eerigi-n g ch agi-n ge orders, th egi-n th e ovegi-n s sh ou ld bear 18 percegi-n t of th e costs of en gin eerin g. Becau se tran saction s are often u sed for assign in g costs of activities to cost objects, activity-based costin g is also called t ran sact io n base d acco u n t -in gor t ran sact io n co st in g.
Illustration of Activity-Based Costing4
Con sider th e Billin g Departm en t at Pacific Power Com pan y (PPC), an electric u tility. Th e Billin g Departm en t (BD) at PPC provides accou n t in qu iry an d bill prin tin g services for two m ajor classes of cu stom ers—residen tial an d com m ercial. Cu rren tly, th e Billin g Departm en t services 120,000 residen tial an d 20,000 com -m ercial cu sto-m er accou n ts.
Two factors are h avin g a sign ifican t im pact on PPC’s profitability. First, deregu lation of th e power in du stry h as led to in creased com petition an d lower rates, so PPC m u st fin d ways of redu cin g its operatin g costs. Secon d, th e dem an d for power in PPC’s area will in crease du e to th e addition of a large h ou sin g devel-opm en t an d a sh oppin g cen tre. Th e m arketin g departm en t estim ates th at resi-den tial dem an d will in crease by alm ost 50 percen t an d com m ercial dem an d will in crease by 10 percen t du rin g th e n ext year. Sin ce th e BD is cu rren tly operatin g at fu ll capacity, it n eeds to fin d ways to create capacity to service th e expected in crease in dem an d. A local service bu reau h as offered to take over th e BD fu n c-tion s at an attractive lower cost (com pared to th e cu rren t cost). Th e service bu reau ’s proposal is to provide all th e fu n ction s of th e BD at $3.50 per residen -tial accou n t an d $8.50 per com m ercial accou n t.
Exh ibit 5-7 depicts th e residen tial an d com m ercial cu stom er classes (cost objects) an d th e resou rces u sed to su pport th e BD. Th e costs associated w ith th e BD are all in direct—th ey can n ot be iden tified specifically an d exclu sively w ith eith er cu stom er class in an econ om ically feasible w ay. Th e BD u sed a tra-dition al costin g system th at allocated all su pport costs based on th e n u m ber of accou n t in qu iries of th e tw o cu stom er classes. Exh ibit 5-7 sh ow s th at th e cost of th e resou rces u sed in th e BD last m on th w as $565,340. BC received 23,000 accou n t in qu iries du rin g th e m on th , so th e in direct cost per in qu iry w as $565,340 ÷ 23,000 = $24.58. Th ere were 18,000 residen tial accou n t in qu iries, abou t 78 percen t of th e total. Th u s, residen tial accou n ts were ch arged with 78 percen t of th e su pport costs wh ile com m ercial accou n ts were ch arged with 22 percen t. Th e resu ltin g cost per accou n t is $3.69 an d $6.15 for residen tial an d com m ercial accou n ts, respectively.
Based on th e costs provided by th e tradition al cost system , th e BD m an -agem en t wou ld be m otivated to accept th e service bu reau ’s proposal to service all residen tial accou n ts becau se of th e apparen t savin gs of $.19 ($3.69 2 $3.50) per accou n t. Th e BD wou ld con tin u e to service its com m ercial accou n ts becau se its costs are $2.35 ($8.50 2 $6.15), less th an th e service bu reau ’s bid.
However, m an agem en t believed th at th e actu al con su m ption of su pport resou rces was m u ch greater th an 22 percen t for com m ercial accou n ts becau se of th eir com plexity. For exam ple, com m ercial accou n ts average 50 lin es per bill com pared with on ly 12 for residen tial accou n ts. Man agem en t was also con -cern ed abou t activities su ch as correspon den ce (an d su pportin g labou r) resu ltin g from cu stom er in qu iries becau se th ese activities are costly bu t do n ot add valu e to PPC’s services from th e cu stom er’s perspective. However, m an agem en t wan ted a m ore th orou gh u n derstan din g of key BD activities an d th eir in terrelation sh ips
4Much of the discussion in this section is based on an illustration used in Implementing
before m akin g im portan t decision s th at wou ld affect PPC’s profitability. Th e com -pan y decided to perform a stu dy of th e BD, u sin g activity-based costin g. Th e fol-lowin g is a description of th e stu dy an d its resu lts.
Th e activity-based-costin g stu dy was perform ed by a team of m an agers from th e BD an d th e ch ief fin an cial officer from PPC. Th e team followed a fou r-step procedu re to con du ct th e stu dy.
Step 1. Determine cost objectives, key activities centres, resources, and related cost drivers. Man agem en t h ad set th e objective for th e stu dy—determ in e th e BD cost per accou n t for each cu stom er class. Th e team iden tified th e followin g activities, resou rces, an d related cost drivers for th e BD th rou gh in terviews with appropri-ate person n el.
The four key BD activity centres are account billing, bill verification, account inquiry, and correspondence. The resources shown in Exhibit 5-7 support these major activity centres. Cost drivers were selected based on two criteria.
1. Th ere h ad to be a reason able assu m ption of a cau se-effect relation sh ip between th e driver u n it an d th e con su m ption of resou rces an d/ or th e occu rren ce of su pportin g activities.
2. Data on th e cost-driver u n its h ad to be available.
Step 2. Develop a process-based map representing the flow of activities, resources, and their interrelationships. An im portan t ph ase of an y activity-based an alysis is iden tifyin g th e in terrelation sh ips between key activities an d th e resou rces con -su m ed. Th is is typically don e by in terviewin g key person n el. On ce th e lin kage between activities an d resou rces is iden tified, a process m ap is drawn th at pro-vides a visu al represen tation of th e operation s of th e BD.
Exhibit 5-8 is a process map that depicts the flow of activities and resources at the BD.5 Note that there are no costs on Exhibit 5-8. BD first focused on
under-standing business processes. Costs were not considered u n til Step 3, after th e key in terrelation sh ips of th e bu sin ess are u n derstood.
Con sider residen tial accou n ts. Th ree key activities su pport th ese accou n ts— accou n t billin g, accou n t in qu iry, an d correspon den ce. Bill prin tin g activity con -su m es prin tin g m ach in e tim e, paper, com pu ter tran saction tim e, billin g labou r tim e, an d su pervisory tim e. Th is activity also takes u p sign ifican t occu pan cy space. Accou n t in qu iry activity con su m es labou r tim e an d requ ires correspon den ce for som e in qu iries. Accou n t in qu iry labou r, in tu rn , u ses th e telecom m u -n icatio-n , com pu ter, su pervisory resou rces, a-n d also occu pies a sig-n ifica-n t am ou -n t of occu pan cy space. Fin ally, th e correspon den ce activity requ ires su pervision an d in qu iry labou r. Th e costs of each of th e resou rces con su m ed were determ in ed
5This example illustrates the process-based modelling approach to activity-based costing. For a more detailed description of the
Telecommunications $58,520
Supervisors $33,600
Account Inquiry Labour $118,400
Printing Machines $55,000
Billing Labour $67,500 Computer
$178,000
Paper $7,320
Occupancy $47,000 Current Costing Based on One Overall Rate
Total Indirect Cost: $565,340
# Inquiries = 23,000
Residential Accounts ($442,440) Commercial Accounts
18,000 (78%) 5,000 (22%)
($122,900)
Cost/ Inquiry
$565,340/ 23,000 #Inquiries #Accounts Cost/ Account
(1) (2) (3) (1)X(2)/ (3)
Residential $24.58 18,000 120,000 $3.69
Commercial $24.58 5,000 20,000 $6.15
EX H I B I T 5 - 7
Step 3. Collect relevant data concerning costs and the physical flow of cost-driver units among resources and activities. Usin g th e process m ap as a gu ide, BD accou n -tan ts collected th e requ ired cost an d operation al data by fu rth er in terviews with relevan t person n el. Sou rces of data in clu de th e accou n tin g records, special stu d-ies, an d som etim es “best estim ates of m an agers.”
EX H I B I T 5 - 8
Process Map of Billing Department Activities
Telecommunications Supervisors
Account Inquiry
Account Billing
Billing Labour
Computer
Paper Occupancy
Residential Account Summary
Commercial Account Summary Correspondence
Accounts Lines
Letters Labour
Hours
Exh ibit 5-9 is a graph ical represen tation of th e data collected for th e fou r activity cen tres iden tified in Step 1. For each activity cen tre, data collected in clu ded traceable costs an d th e ph ysical flow of cost-driver u n its. For exam ple, Exh ibit 5-9 sh ows traceable costs of $235,777 for th e accou n t billin g activity. Traceable costs in clu de th e costs of th e prin tin g m ach in es ($55,000 from Exh ibit 5-7) plu s portion s of th e costs of all oth er resou rces th at su pport th e billin g activ-ity (paper, occu pan cy, com pu ter, an d billin g labou r). Notice th at th e total trace-able costs of $205,332 + $35,384 + $235,777 + $88,847 = $565,340 in Exh ibit 5-9 equ als th e total in direct costs in Exh ibit 5-7. Next, th e ph ysical flow of costdriver u n its was determ in ed for each activity or cost object. For each activity cen -tre, th e traceable costs were divided by th e su m of th e ph ysical flows to establish a cost per cost-driver u n it.
Step 4. Calculate and interpret the new activity-based information.Th e activ-ity-based cost per accou n t for each cu stom er class can be determ in ed from th e data in Step 3. Exh ibit 5-10 sh ows th e com pu tation s.
Account Inquiry Account Billing
1,800 labour hours 1,800 letters 1,440,000 lines
1,500 labour hours 1,000 letters 1,000,000 lines Correspondence
$62.22 per labour hour
$12.64 per letter
$0.097 per line
$4.44 per account Account Verification
$205,332 $35,384 $235,777 $88,847
3,300 labour hours 2,800 letters 2,440,000 lines 20,000 accounts Billing Department Activity Centres Total Traceable Cost, $565,340
Cost objects: Physical flow of cost-driver units for each cost object: Traceable Costs: Physical flow of cost-driver units:
EX H I B I T 5 - 9
