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QUESTIONS
1. Indirect costs are allocated to (1) provide information for decision making, (2) reduce
frivolous use of common resources, (3) encourage evaluation of internally provided
services, and (4) calculate the “full cost” of products for GAAP reporting.
2. The statement is false. Cost allocation refers to the process of assigning indirect costs.
Direct costs are traced to cost objects. Costs are allocated for a variety of reasons. It is not
economically feasible to directly trace some costs to cost objects—these costs are classified
as indirect costs and are allocated to the cost object via the use of an allocation base.
3. Charging for internal services can reduce frivolous use of resources and encourage
departments being charged to critically evaluate the service. In addition, GAAP requires
that all manufacturing costs be assigned to goods being produced. Thus, cost allocation of
indirect manufacturing costs is required.
4. Cost-plus contracts specify that the contractor will be paid for the cost of production (or
services) plus some fixed amount or percentage of cost. Defense contracts with the federal
government are often cost-plus contracts.
A major problem with cost-plus contracts is that they give the contractor an incentive to
allocate as much cost as possible to the cost-plus contract (via the choice of an allocation
base) where it will be reimbursed.
5. A cost objective is a product, service, or department that receives an allocation of cost. For
example, a production department that receives an allocation of janitorial cost is a cost
objective. Likewise, a product in a department that receives an allocation of depreciation of
equipment is a cost objective.
6. A cost pool is a collection of individual indirect costs whose total is allocated using one
allocation base. Cost pools are often formed along department lines. For example, the
maintenance cost pool would include all costs of the maintenance department.
7. A concern in forming a cost pool is that the costs within the cost pool be similar or
homogeneous. It is unlikely that variable and fixed costs are similar (i.e., that one
allocation base is suitable for allocating both fixed and variable costs). Homogeneous cost
pools provide more accurate information.
6-2 Jiambalvo Managerial Accounting
10. If budgeted costs are allocated, then service departments cannot pass on inefficiencies and
waste. Allocating actual costs gives the service department little incentive to be efficient.
11. In a responsibility accounting system, revenues and costs are traced to departments/
divisions and individuals with related responsibility for generating revenues and controlling
costs. This facilitates performance evaluation of managers and the operations under their
control.
12. Sometimes managers are allocated costs beyond their control in order to make them aware
that the cost exist and must be covered by revenues of the firm.
13. Unitizing fixed costs make them appear to be variable. If the unitized fixed costs are then
allocated to divisions based on, for example, revenue, divisional managers may make
decisions in order to maximize divisional profits that are not in the company’s best interest.
This problem can be avoided by lump-sum allocations of fixed costs.
14. Traditional allocation methods use a small number of cost pools and allocation bases
related to production volume. However, some costly activities are not related to production
volume. Consider the costs associated with setups—in a traditional costing system setup
costs would be allocated based on production volume and high volume products will
receive most of the allocated cost even though low volume products may require an equal
number of setups.
15. The traditional costing approach typically uses allocation bases that are measures of
production volume (e.g., direct labor hours, direct labor cost, or machine hours). Also, few
cost pools are used under the traditional approach (e.g., one or two cost pools).
ABC focuses on major activities that cause overhead costs to be incurred. Many of these
activities are not related to production volume. Cost pools are formed for each major
activity and costs are assigned to products using an allocation base that is a cost driver.
Many of the cost drivers are not related to production volume. ABC typically uses more
cost pools and related cost drivers.
Chapter 6 Cost Allocation and Activity-Based Costing 6-3
16. ABC will tend to give more accurate costs than a traditional cost system when:
(1) the production process is complex and varied (high and low volume products),
(2) products consume resources differently, and
(3) there are activities that are not related to production volume (e.g., setups).
17. (1) ABC is more costly to develop and maintain than a traditional system.
(2) In practice, ABC is used to develop the full cost of products. The ABC cost per unit
does not measure the incremental costs needed to produce an item. Therefore, it is not
always useful for decision making.
18. ABC focuses on activities with the goal of measuring costs of products and services
produced by the firm. ABM focuses on activities with the goal of managing the activities
themselves. ABC has the goal of accurately computing costs of products and services while
ABM focuses on reducing the costs of or the demand for major activities.
6-4 Jiambalvo Managerial Accounting
EXERCISES
E1. Fixed costs (e.g., administrative costs) are sometimes allocated based on a
measure of business activity (e.g., sales). This makes the costs appear to be
variable (e.g., the higher sales, the higher the allocation of administrative
cost). In turn, this may lead to poor decisions if managers treat the allocated
costs as incremental.
These allocations are not “cause and effect” allocations. Consider building
depreciation. When a unit occupies space, it doesn’t cause cost equal to
allocated depreciation. It may be that the space wasn’t occupied, in which
case no cost was caused. Or, occupancy may have led to a need to rent
additional space, causing a cost much higher than allocated depreciation.
Rather, the allocations are based on “relative benefit.” Thus, for example, if
you occupied space you benefited! And the assumption is that your benefit
was proportionate to space occupied.
voice concerns about the cost of security service. This may make the security
department more efficient. In addition, allocation of security costs that relate
to manufacturing are required under GAAP.
b. Under the direct method costs are not allocated between service
departments. Thus, the Human Resource department would not receive a
share of Food Services costs.
(2) An allocation base that results in a cause and effect allocation is preferred.
If maintenance costs are mostly related to building maintenance, then square
footage is more likely to result in a cause and effect allocation. However, if
maintenance costs are mostly made up of machine maintenance, then machine
hours might be a better allocation base.
E9. a. The manufacturing overhead allocation includes $52 of fixed cost which
will not increase if the special order is accepted (i.e., it is not an
incremental cost). The incremental revenue and incremental costs
associated with the order suggests that the company will be better off by
$45,000 if the order is accepted.
b. Managers who focus on reported cost may (incorrectly) treat the $52 of
fixed cost as an incremental cost. In this case they will (incorrectly)
conclude that the order should not be accepted because the total cost
($182) is greater than the offer ($175).
Chapter 6 Cost Allocation and Activity-Based Costing 6-7
E10. a. The reason that allocated general and administrative costs are higher for
the Services Department is that revenue in the Sales Department has
decreased. Since general and administrative costs are allocated based on
actual revenues, changes in one department’s revenue affects another
department’s allocation of overhead costs (since it has a higher
proportion of total revenue).
E11. a. The manager of Keller Auto Insurance will perceive that allocated service
department costs are variable cost (when auto insurance revenue
increases, the allocated costs increase).
Each product requires 5 direct labor hours in total. Therefore, each will be
allocated $37.50 in overhead costs ($7.50 × 5)
Now let’s calculate the amount of overhead allocated to each product if Mott
used a separate overhead cost pool for each production department.
P1’s overhead rate will be $2,000,000 ÷ 100,000 DLH = $20.00 per direct
labor hour.
P2’s overhead rate will be $1,000,000 ÷ 300,000 DLH = $3.33 per direct
labor hour.
Note that the overhead allocated to B1 is lower with two cost pools while the
allocation to A1 is higher.
E13. a. If the costs of the design department are fixed and the department is able
to complete jobs on a timely basis, then the opportunity cost of using the
department is approximately zero and equal to the allocation (which is
also zero).
c. The allocation of $50 per hour must be less than the opportunity cost
(subsidiaries are willing to pay $70 per hour to avoid delays). Thus, they
must have a benefit that exceeds $70.
Chapter 6 Cost Allocation and Activity-Based Costing 6-9
d. The opportunity cost of using design services may be less than $50 since
no one is being turned away or delayed. Thus, there does not appear to be
a benefit foregone because of use.
E16. If the cost to process an order is much higher at one plant than at the other
and the orders are similar, then there is a good chance that the costs are out
of control at the higher cost location and a manager should investigate the
situation. Conceivably, the company can adopt “best practices” from the
low cost plant.
PROBLEMS
Software Consulting
Sales $10,000,000 $5,000,000
Less direct costs 5,000,000 3,000,000
Less allocated costs 2,683,334 1,316,666
Income before taxes $ 2,316,666 $ 683,334
Using multiple cost pools and multiple allocation bases allocates $316,666
more overhead cost to consulting than a single allocation base method.
P2. a. The opportunity cost of producing a Model 350 motor is simply the
incremental cost of production (given that Binder has excess capacity and
sales to Dacon will not affect sales to other customers).
b. Since 60 percent of the overhead is fixed ($12 per motor), the incremental cost
to produce the motors is $38 per motor ($20 + 10 + 8). Any bid greater than
$38 (that’s accepted) will generate incremental profit. If Binder can get the
order with a bid of $48, the company should bid this amount. It will generate
incremental profit of $50,000 [($48 - $38) × 5,000 motors].
c. The opportunity cost related to overhead, in this case, is simply the variable
overhead amount. An allocation based on the opportunity cost idea, helps
managers focus on incremental costs—the information needed for decision
making.
6-12 Jiambalvo Managerial Accounting
Civilian Military
Labor$ Mach.Hrs. Labor$ Mach.Hrs.
Direct material $2,000 $ 2,000 $ 2,500 $ 2,500
Direct labor 600 600 900 900
Overhead 6,000 8,000 9,000 8,000
Cost $8,600 $10,600 $12,400 $11,400
b. The price charged for the civilian version of the Model KV10 does not
depend on allocated costs. However, the military version is sold for “cost”
plus 10 percent of cost. Therefore, the company has an incentive to make
cost appear higher rather than lower. This can be accomplished by
allocating overhead cost using direct labor cost as the allocation base. This
base results in a higher cost ($12,400) compared to an allocation based on
machine hours which results in a cost of only $11,400.
c. Many, if not most, managers believe that “it is well known that allocation
is somewhat arbitrary and the government is not at all surprised that
companies pick allocation bases to maximize their profit.” Since no one is
being “fooled,” the behavior is not illegal, and the “right” allocation isn’t
obvious, picking an allocation base to maximize profit does not appear to
be unethical.
Chapter 6 Cost Allocation and Activity-Based Costing 6-13
P6. a.
Allocation Base Financial Planning Business Consulting
Proportion Amount Proportion Amount
Salaries .667 $666,667 .333 $333,333
Headcount .750 $750,000 .250 $250,000
b. Both headcount and salary appear to be plausible allocation bases, but they
result in very different allocations. This suggests that in many cases
allocations are somewhat arbitrary.
The current overhead cost for an 8 labor-hour job is 60% more than the prior
overhead cost.
b. Small jobs in the current year appear to be less profitable compared to the
prior year. This is because they are allocated overhead costs as if they
required use of the new equipment. Therefore, small jobs will be
overcosted. In all likelihood, the jobs do not really cost more than they did
in the prior year. One way to avoid miscosting of small (labor-intensive)
jobs would be to develop a separate overhead allocation rate for jobs that
are labor intensive and do not make use of the new equipment.
Chapter 6 Cost Allocation and Activity-Based Costing 6-15
P8. a. The recreation kayaks are uniform and probably made in large batches. The
competition kayaks are custom made one at a time. Several costs in the
overhead cost pool are probably less expensive on a per unit bases for
recreation versus competition kayaks. For example, each competition kayak
probably requires (on average) more equipment time, quality control, and
setup and drafting costs compared to each recreation kayak.
b. Summit needs to look at the costs of activities that each line of kayaks
requires. Summit could get more accurate costs if each of the major
overhead cost components were allocated to the kayak line using an
appropriate cost driver.
c.
Cost Pool Cost Recreation Competition
use of base allocation use of base allocation
Building $ 25,000 .857 $ 21,429 .143 $ 3,571
Equipment 25,000 .850 21,250 .150 3,750
Materials ordering 15,000 .667 10,000 .333 5,000
Quality control 10,000 .667 6,667 .333 3,333
Maintenance & security 10,000 .857 8,571 .143 1,429
Set up and drafting 20,000 .333 6,667 .667 13,333
Supervision 30,000 .900 27,000 .100 3,000
Total $135,000 $101,584 $33,416
Per kayak $112.87 $334.16
Recreation Competition
Direct materials $150.00 200.00
Direct labor 100.00 100.00
Overhead 112.87 334.16
Total unit cost 362.87 634.16
Sales price 600.00 660.00
Gross Profit $237.13 $ 25.84
6-16 Jiambalvo Managerial Accounting
P9. a.
Cost Pool Overhead rate
Materials ordering $800,000 ÷ 100,000 = $8.00 / order
Materials inspection $400,000 ÷ 2,000 = $200 / rec. report
Equipment setup $2,000,000 ÷ 100 = $20,000 / setup
Quality control $900,000 ÷ 4,000 = $225 / inspection
Other $15,000,000 ÷ $10,000,000 = $1.50 / labor cost
d. Total unit costs per unit of Remote Mouse = $31 + $6 + $17.90 = $54.90
The direct labor cost, per unit, for the Remote Mouse:
($120,000 ÷ 20,000 units) $6.00
ABC assigns $6.44 more overhead to each unit of Remote Mouse than is
assigned using a traditional production volume base. Remote Mouse
production uses only 1.2 percent of direct labor dollars, but requires 10
percent of materials ordering, 15 percent of materials inspection, and 10
percent of quality control resources. Remote Mouse production uses a
relatively a small amount of direct labor dollars and is therefore undercosted a
traditional approach to allocation.
The benchmark cost is $30 per completed trip. Thus, it appears that
Baxter’s costs are relatively high (33% more than the benchmark), and
process improvement is warranted.
b. The wages paid to employees who book travel are $630,000 (14 employees
× $45,000.
P11. a. A sophisticated Web site and call center can reduce demands placed on
tellers to process deposits, process withdrawals, deal with requests for
CDs, answer questions related to balances, and respond to requests for
statements. A sophisticated Web site or call center will not impact teller
time to provide access to safe deposit boxes or reconcile the cash drawer.
P12. With 6,000 employees and turnover of 15%, 900 people leave the company
and 900 are added to take their place each year (.15 x 6,000). With this in
mind, having 6 employees to handle new employee training appears
excessive. Suppose each new employee requires a half day of training. That
implies 450 training days. Assume that each trainer works 5 days per week
for 48 weeks per year. Then, each trainer covers 240 training days. Thus,
only 2 trainers are needed (450 ÷ 240 = 1.875). Reducing trainers by 4 would
save $20,000 in salary each month.
Now, consider operations. It’s not clear that 5 clerks are needed. Suppose
paperwork related to resignations and new hires is 2 hours per person. This
implies a need for 3,600 hours (2 hours x 1,800 resignations or hires).
Assuming each clerk works 8 hours per day, with a 5 day work week for 48
weeks, a clerk has 1,920 hours. Again, it appears that only 2 clerks are
needed (3,600 ÷ 1,920 = 1.875). A reduction of 3 clerks would save $7,500
per month.
Note that the total savings is estimated to be $27,500 per month or $330,000
per year. Assuming the ABM study reduced waste for 3 years, the company
would save approximately $1,000,000. If similar savings could be found in
other departments, ABM would create substantial shareholder value.