We then assess the performance of the cost allocation and allocate EZ-Rest's capacity costs to its two products. Suppose we decide to allocate EZ-Rest's fixed capacity costs across its two product lines, using direct labor dollars (DL$) as an allocation basis. Both the single- and dual-pole systems assume the full capacity costs of EZ-Rest.
Cost Allocations for reporting income
Even though EZ-Rest is currently operating at capacity, CEO Craig Edwards wants the company to increase its profits. Using the single-pool cost allocation system, we estimate that profit will decrease until EZ-Rest changes its product mix. Using the two-pool cost allocation system, we estimate that profit would decrease by up to $100,000 if EZ-Rest changed its product mix.
CHAPtER COnnECtIOnS
Cost Allocations for Revenue Reporting 365. You may also want to review Chapter 3's discussion of cost flow in manufacturing companies, and in particular Appendices 3.7 and 3.12.) So EZ-Rest charges $295 (materials) 1 $75 ( labour costs). ) 1 $120 (production costs at $1.60 per labor $) $490 as the inventory value for each standard mattress. To understand how absorption costing affects reported revenues, assume that EZ-Rest continued to make 18,000 Standard and 12,000 Deluxe mattresses, as in Exhibit 9.1, but sold only 17,000 Standard and 11,600 Deluxe mattresses. Once again, as we expect, reported revenues were down from $684,000, which was the income when EZ-Rest sold all units produced.
Check it! Exercise #3
As shown in the left-hand circles of panels B and C, EZ-Rest also spent on fixed manufacturing costs. Consequently, when inventory levels change, the amount recognized in the income statement for overhead may not match the amount spent. How the firm allocates overhead determines the portion recognized in the income statement and thus reported income.
This means that overhead costs associated with units sold are shown on the income statement, while overhead costs for units placed in inventory are shown on the balance sheet. When EZ-Rest adds units to inventory, this overhead accounting leads to higher reported income relative to the income reported under variable costs.
An Example
The price of a meal sold to the public is $8; the price for the military allows for a 20% markup on costs. Because Ryan's reimbursement from the military is cost-based, he must decide how to divide the $8 million in fixed costs between the military and the public. The military contract allows Ryan to use either the number of meals or machine hours to allocate fixed costs.
Connecting to Practice
Check it! Exercise #4
Using CosT ALLoCATions To infLUEnCE bEhAvior
Allocations to induce Desired behavior
Faced with the task of motivating its workforce to use the new technology, corporate headquarters is rethinking its employee incentives. Although the allocation results in a significant charge on each division's profit, the head office does provide numerous support services to the divisions. As a motivation to use the new technology, the chief financial officer (CFO) suggests changing this allocation procedure and using direct labor hours as the basis for allocating corporate overhead.
The company will thus allocate the most overhead to the division that uses the most direct labor hours in its production process. The result is a natural incentive for the workforce in the division to choose new technology and automation to lower the amount of direct labor. As shown in Exhibit 9.11, the quantity demanded of any resource (vertical axis) falls as the price (horizontal axis) rises.
Allocating overhead costs in proportion to the use of a resource effectively increases its price, and therefore the quantity demanded decreases.
Allocations to induce Efficient Use
Melanie concludes that the faculty and staff are using Brad's services inefficiently because they view Brad's time as a "free commodity." Since Brad's time is not billed, everyone asks Brad for help, even with minor problems. Being a shrewd accountant, Melanie decides to charge teachers and staff an hourly rate for using Brad's services. Each time a faculty member uses Brad's services, he chooses to bill his usage account at a rate of $30 per hour.
This forces faculty members to evaluate whether it is worth paying for Brad's services at $30 an hour, or whether they should solve the problem themselves. Because the allocated cost serves as the price for using Brad's services, Melanie can further increase efficiency. That is, she can increase or decrease the demand for Brad's time by changing the hourly rate.
Many universities use such cost allocation procedures to reduce unnecessary and wasteful use of expensive resources. The use of cost allocations for this purpose serves as a simple and effective way to influence employees' use of resources, especially the expensive ones. So far, we have described three different demands for cost allocations: estimating long-term capacity costs, determining reported revenue, and influencing behavior.
C ost a lloCations in J aPan
For this decision, the need to allocate costs arose from two fundamental principles: (1) the controllability of capacity costs in the long term caused EZ-Rest to measure these costs for appropriate decision-making; (2) the lack of traceability of capacity costs for individual products has led to a demand for allocations. We learned that organizations use cost allocation for several purposes, including decision-making, reporting revenue to external parties, justifying reimbursements, and influencing behavior. When compiling a contribution margin statement, we do not need to use cost allocation to arrive at net income or inventory value.
Cost allocations play an important role in determining income reported under Generally Accepted Accounting Principles (GAAP). Because these costs are indirect, firms use cost allocations to value inventory and in turn determine cost of goods sold and net income. Increases or decreases in inventory levels will cause income under variable costing to differ from income under absorption costing.
Cost allocations are a way of penalizing and thus discouraging the use of one resource in favor of another. In addition, cost allocations can induce the efficient use of resources shared by multiple users by discouraging wasteful use. Essentially, sales, the unit contribution margin, and fixed costs determine revenue reported under variable costs.
We also note that Bath does not use any cost allocations to arrive at monthly revenues or inventory values when constructing the variable costing statement.
Check it! Exercise #5
Absorption Costing
However, as mentioned in the chapter, this approach is not acceptable under GAAP for external reporting purposes. Keep in mind that because manufacturing overhead "travels" with the units, the goods sold account will include the fixed manufacturing costs of units sold. The Finished Goods Inventory account will contain the fixed manufacturing costs for units produced but not sold.
So if we focus only on fixed manufacturing costs, we see that cost of goods sold contains fixed manufacturing overhead and finished goods inventory contains the remaining $51,000. The matching principle, a fundamental principle of GAAP, requires companies to recognize expenses in the same period in which the related revenue is generated. GAAP defines fixed manufacturing costs as part of the cost of producing a unit and requires companies to record the cost of a product as an expense only in the period in which they make the sale and recognize the related revenue.
When the sale finally occurs, the fixed production costs are included in the cost of goods sold for that accounting period. A common criticism of absorption costing is that it provides incentives to produce more than necessary to meet demand. This 'hiding' of the overhead costs in inventory is the source of the extra 'profit' in July.
These costs will become part of cost of goods sold in a future period when Bath sells these 5,000 units.
Because this change in the allocation rate changes neither revenue nor variable costs, gross margin per unit increases by $85 per unit, from $175 per unit to $260 per unit. Managers may want to increase their reported income if they receive bonuses based on the income they report. In our example, Bath reports revenue of $435,000 for July under both variable costing and absorption costing because production equals sales and the company had zero units in beginning inventory.
Note that this difference in income corresponds to the difference in ending inventory values—ending inventory under absorption costing is $105,000, whereas it is only $54,000 under variable costing. The $51,000 represents the fixed manufacturing costs in ending inventory under absorption costing (200 unsold tubs 3 $255 fixed manufacturing costs per tub). In September, revenue reported under absorption costing was $51,000 less than revenue reported under variable costing because Bath sold its inventory of 200 tubs.
Under absorption costing, however, the cost also includes $51,000 in fixed manufacturing costs allocated to the ending inventory of 200 units in August. These costs become part of COGS for September when Bath sells the units it inventoried in August. Complete the table below to reconcile the revenue numbers reported under variable costing and absorption costing.
Check it! Exercise #6
- LO1. What is the difference between a contribution margin and a profit margin?
- LO1. What are the two approaches for estimating the controllable cost of capacity resources over the long
- LO2. What costs does the value of a unit of product include under absorption costing?
- LO2. Under variable costing, how does sales volume affect the amount of fixed manufacturing overhead
- LO3. How could a firm induce desirable behavior or dissuade undesirable behavior by changing its cost
- LO3. What are the two main influences that guide the choice of a cost allocation procedure?
- Appendix. What is the formula for reconciling income reported under variable costing with income
- LO1. Suppose a firm currently makes three products using the same capacity resources and that one of the
- LO1 (Advanced). When using allocated costs for decision making, we assume that capacity costs will
- LO2 (Advanced). Do you believe GAAP should allow variable costing for external reporting? Why
- LO2. GAAP usually excludes research and devel- opment costs from its definition of inventoriable
- LO2. “Depreciation is nothing but an allocation of the purchase price over different accounting
- LO3. Firms that allocate costs based on head count motivate their managers to reduce the number of
- LO3. Suppose a firm allocates costs to its individual product lines using labor cost as the allocation basis
- LO3. Even when a decision is short term, the use of allocated costs in managerial performance evaluation
- Absorption costing, income, and inventory effects of alternative allocation bases (LO2)
- Variable costing versus absorption costing, Income Reconciliation (LO2). Horizon Manufacturing provides you with the following information for the most recent month
- Allocations under absorption costing, GAAP inventory valuation, two departments (LO2)
- Variable costing versus absorption costing, income reconciliation (LO2, Advanced)
Which of the two allocation bases, labor cost or material cost, will result in Charlie reporting higher income for the year. What is the inventory cost per unit of each of the three bearings under absorption costing. Additionally, calculate the ending inventory value of Creative Tiles at variable cost.
Which of the two estimates, in part (b) or part (c), do you think is a superior estimate of the profit with the new mix. Due to the time required, Atsuko has received all orders related to the current year. Apollo is a long-time customer, while Troy is an up-and-coming prospect, which is part of the reason for the price cut.
Calculate the variable cost and the allocated fixed cost per unit of the standard and the special product. What is the purpose of distributing the cost of the new software product to the users. Your company allocates material handling costs to products using the number of unique components (ie, the number of components used by this product alone) as the driver.
She had only consumed soft drinks and the cost of the drinks represented at least half of the total bill. What is the purpose of dividing the cost of the bill among the six friends? Suppose the friends had agreed at the beginning of the meal to split the costs equally.
