Part 1 Study Unit 6 Cost Allocation Techniques Jim Clemons, CMA
Absorption versus Variable Costing You need to be able to answer the following: Under absorption costing, which cost are considered product cost? Which costs are considered period cost? In the variable costing, which costs are considered product cost? Which costs are considered period cost? What income statement format is appropriate for variable cost? When is income of the variable costing higher than income and absorption costing? What format can be used to calculate the difference between income under variable costing and income and absorption costing? What managerial behavior does variable costs were render ineffective?
6.1 Absorption and Variable Costing Theory Overview Product cost consist of all the costs incurred the production of a product: direct materials, direct labor, and manufacturing overhead. The process to classified all these costs as part of product costs is referred to as absorption costing (or full costing). Absorption costing is the cost accumulation method required by generally accepted accounting principles (GAAP) for external reporting, and by regulatory body such as the Internal Revenue Service. continued
6.1 Absorption and Variable Costing Theory Overview The main reason is that absorption costing satisfies the matching principle, which states that expenses should be matched with revenues they generate. Based on the matching principle, our product cost flow through raw materials inventory, work in process inventory, and finished goods inventory until the goods are sold.
6.1 Absorption and Variable Costing Theory Overview One thing you have to ask yourself is, if inventory unit costs combined variable cost (typically direct materials, direct labor, and overhead) with fixed cost (typically overhead), how can managers make sound decisions? One way is to use variable costing (or direct costing) in which only variable product costs are accumulated in the inventory accounts. In variable costing, fixed manufacturing overhead is treated as a period expense rather than product cost, meaning it is expensed in the period in which it is incurred.
6.1 Absorption and Variable Costing Theory Overview The main advantage other variable costing method is that income cannot be manipulated by management action, whereas management can manipulated income when using absorption method.
Absorption Costing Sales - Product Costs (incl. fixed and variable) = Gross Margin - Total S, G & A (fixed and Variable)
Variable Costing Sales - Product Cost (only variable cost) = Contribution Margin (portion available to cover fixed costs - Fixed Costs (both mfg. and S, G & A) - Under variable costing, fixed overhead is considered a cost of maintaining capacity, not a cost of producing a product. - Contribution margin will tell you if you are covering at least the direct product costs
6.1 Absorption and Variable Costing Theory See comparison problem shown on page 183
6.1 Absorption and Variable Costing Theory See extended example on page 184-185
6.1 Absorption and Variable Costing Theory Impact on Operating Income Produced = Sold = no difference in income Produced > Sold > income When production exceeds sales, fewer fixed cost are expensed under the absorption basis, and operating income always increases. A production manager can thus increase absorption-based operating income by increasing production, whether there is any customer demand for the additional product or not. This practice, called producing for inventory, can be effectively discouraged by using variable costing for performance reporting and consequent bonus calculation.
6.1 Absorption and Variable Costing Theory Produced < Sold < income Variable costing will show a higher income in periods when inventories decline because absorption method forces the subtraction of all of the current fixed costs, plus some fixed costs incurred (and capitalized) in prior periods. Most importantly, in using variable costing, profits always move in the same direction as sales volume. Profits reported on absorption costing behave erratically and sometimes move in the opposite direction from sales trends.
6.1 Absorption and Variable Costing Theory
SU 6.1 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques Which method of inventory costing treats direct manufacturing costs and manufacturing overhead costs, both variable and fixed, as inventoriable costs? A. Direct costing. B. Variable costing. C. Absorption costing. D. Conversion costing.
SU 6.1 Question 1 Answer Correct Answer: C Absorption (full) costing considers all manufacturing costs to be inventoriable as product costs. These costs include variable and fixed manufacturing costs, whether direct or indirect. The alternative to absorption is known as variable (direct) costing. Incorrect Answers: A: Variable (direct) costing does not inventory fixed overhead. B: Variable (direct) costing does not inventory fixed overhead. D: Conversion costs include direct labor and overhead but not direct materials.
SU 6.1 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques Huntington Corporation pays bonuses to its managers based on operating income, as calculated under variable costing. It is now 2 months before year end, and earnings have been depressed for some time. Which one of the following actions should Wanda Richards, production manager, definitely implement if she desires to maximize her bonus for this year? A. B. C. D. Step up production so that more manufacturing costs are deferred into inventory. Cut $2.3 million of advertising and marketing costs. Postpone $1.8 million of discretionary equipment maintenance until next year. Implement, with the aid of the controller, an activity-based costing and activity-based management system.
SU 6.1 Question 2 Answer Correct Answer: C Because the production manager wishes to maximize her bonus for the coming year, the action she must take will necessarily have most of its effect in the short run. The action she should take to achieve this goal is to defer costs under her control until the following period. Incorrect Answers: A: The perverse incentive to produce for inventory only works under absorption costing. B: The production manager has no control over advertising and marketing costs. D: Activity-based costing and activity-based management require time, effort, and resources in the short run and only show benefits over the long run.
Variable Costing Practical Exercise
Variable Costing Practical Exercise Solutions
6.1 Absorption and Variable Costing Theory continued Other benefits of variable costing: Variable costing is better suited for management's needs which requires a knowledge of cost behavior under various operating conditions. For planning and control, management is more concerned with treating fixed and variable costs separately than with calculating full cost. Full costs are usually dubious value because they contain arbitrary allocation of fixed cost. The production manager cannot manipulate income levels over overproducing. continued
6.1 Absorption and Variable Costing Theory The cost data for profit planning and decision-making are readily available from accounting records and statements under variable costing. For example cost profit relationships and the effects of changes in sales volume on that income can easily be computed from income statement prepared under the variable costing concept, but not from the conventional absorption costing income statement based on the same data. Absorption cost income statements may show decreases in profits from sales and rising and increases in profits from sales or decreasing, which may be confusing to management. A favorable margin in the variable costing justifies a higher production level. Variable costing is also preferred over absorption costing for studies of relative profitability of products, territories, and other segments of a business. A concentrate on the contribution of each segment makes to the recovery of fixed costs that will not be altered by decisions to make and sell. continued
6.1 Absorption and Variable Costing Theory Inventory changes have no effect on the breakeven computation. Disinvestment decisions are facilitated because were their product or department is recouping its variable cost can be determined. If the variable costs are being covered operating a department at apparent loss may be profitable. Cost figures are guided by the sales figures. Under variable costing cost of goods sold very directly with sales volume, and the influence of production of gross profit is avoided. There will costing also eliminates a possible difficulties have explain over and under applied factory overhead to higher management.
6.2 Absorption and Variable Costing - Calculations See examples 5 & 6 on page 203
SU 6.2 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques A manufacturing company employs variable costing for internal reporting and analysis purposes. However, it converts its records to absorption costing for external reporting. The Accounting Department always reconciles the two operating income figures to assure that no errors have occurred in the conversion. The fixed manufacturing overhead cost per unit was based on the planned level of production of 480,000 units. Financial data for the year are presented below:
SU 6.2 Question 1 Answer (continued) Budget Actual Sales (in units) 495,000 510,000 Production (in units) 480,000 500,000 Variable Costing Absorption Costing Variable costs $10.00 $10.00 Fixed manufacturing overhead 0 6 Total unit manufacturing costs $10.00 $16.00
SU 6.2 Question 1 (continued) The difference between the operating income calculated under the variable costing method and the operating income calculated under the absorption costing method would be A. $57,600 B. $60,000 C. $90,000 D. $120,000
SU 6.2 Question 1 Answer Correct Answer: B The difference between variable costing and absorption costing is that the former treats fixed manufacturing overhead as a period cost. The latter method treats it as a product cost. Given that sales exceeded production, both methods expense all fixed manufacturing overhead incurred during the year. However, 10,000 units (510,000 sales 500,000 production) manufactured in a prior period were also sold. These units presumably were recorded at $10 under variable costing and $16 under absorption costing. Consequently, absorption costing operating income is $60,000 (10,000 units $6) less than that under variable costing. Incorrect Answers: A: The amount of $57,600 equals 10,000 units times $5.76 per unit (total budgeted fixed manufacturing overhead 500,000 units). C: The amount of $90,000 is the difference between planned sales (495,000 units) and actual sales (510,000 units), times the fixed manufacturing overhead per unit ($6). D: The amount of $120,000 is the volume variance under absorption costing.
SU 6.2 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques Pontotoc Industries manufactures a product that is used as a subcomponent by other manufacturers. It has the following price and cost structure: Selling price $300 Costs Direct materials $40 Direct labor 30 Variable manufacturing overhead 24 Fixed manufacturing overhead 60 Variable selling 6 Fixed selling and administrative 20-180 Operating margin $120
SU 6.2 Question 2 (continued) What will the contribution margin per unit be if the company sells 10,000 units? A. $206 B. $200 C. $140 D. $120
SU 6.2 Question 2 Answer Correct Answer: B Contribution margin is the excess of sales over variable costs. Sales will be at $300 per unit. Variable costs are $100, consisting of $40 of direct materials, $30 of direct labor, $24 of variable overhead, and $6 of variable selling costs. Thus, the contribution margin will be $200 per unit ($300 $100). Incorrect Answers: A: Excluding variable selling costs results in $206. C: Including fixed manufacturing overhead results in $140. D: This amount is the operating margin.
6.3 Joint Product and By-Product Joint processing and the split off point Joint (common) cost are those costs incurred up to the point where products become separately identifiable, called the split off point. They can include direct materials direct labor and manufacturing overhead, and must be allocated to the individual joint products. Separable cost and be identified with a particular joint product and allocated to a specific unit of output.
6.3 Joint Product and By-Product Since joint cost cannot be traced to individual products, they must be allocated. There essentially four methods of doing so: 1. Physical-measure-based approach 2. Market-based approach 1. Sales value at split off method 2. Estimated net realizable value method 3. Constant gross margin percentage NRV method
6.3 Joint Product and By-Product See examples on page 188-190
6.3 Joint Product and By-Product By-products - Are products of relatively small total value that are produced simultaneously from a common manufacturing process with products of greater value and quantity. If additional processing and selling cost exceed the selling price they should be scrapped. If they can be processed further at a gain than the question becomes are the byproduct material, and if so they should be capitalized in a separate inventory account, which essentially reduces the cost of goods sold. If the byproducts are immaterial after further processing their not recognize until the time of sale.
SU 6.3 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques In joint-product costing and analysis, which one of the following costs is relevant when deciding the point at which a product should be sold to maximize profits? A. Separable costs after the split-off point. B. Joint costs to the split-off point. C. Sales salaries for the period when the units were produced. D. Purchase costs of the materials required for the joint products.
SU 6.3 Question 1 Answer Correct Answer: A Joint products are created from processing a common input. Joint costs are incurred prior to the split-off point and cannot be identified with a particular joint product. As a result, joint costs are irrelevant to the timing of sale. However, separable costs incurred after the split-off point are relevant because, if incremental revenues exceed the separable costs, products should be processed further, not sold at the split-off point. Incorrect Answers: B: Joint costs have no effect on the decision as to when to sell a product. C: Sales salaries for the production period do not affect the decision. D: Purchase costs are joint costs.
SU 6.3 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques The primary purpose for allocating common costs to joint products is to determine A. The selling price of a by-product. B. Whether one of the joint products should be discontinued. C. D. The variance between budgeted and actual common costs. The inventory cost of joint products for financial reporting.
SU 6.3 Question 2 Answer Correct Answer: D Joint products must be valued for external financial reporting purposes based on the full (absorption) cost of the product. Any common costs attributable to the joint production process must therefore be allocated on a systematic and rational basis. Incorrect Answers: A: The selling price of a by-product is determined by market forces outside the manufacturer s control, not by the manufacturer s cost structure. B: The decision to discontinue a joint product is based on the incremental profit from that product, not the allocation of common costs. C: A variance between budgeted and actual costs is scrutinized regardless of the method of allocating common costs.
6.4 OH and Normal Costing All manufacturing costs that are not DM/DL MOH = Factory OH = Indirect Pdt Cost (Indirect Materials, Indirect Labor, Supplies, Utilities, Insurance, Taxes, Depreciation) Costs outside the product cost (G&A, Selling) are not inventoriable in COGS = P&L DL and DM are purely variable costs OH contains both Variable and Fixed costs
What is Normal Costing? Normal costing is used to derive the cost of a product. It includes the following components: Actual cost of materials Actual cost of labor A standard overhead rate that is applied using the product's actual usage of whatever allocation base is being used (such as direct labor hours or machine time) If there is a difference between the standard overhead cost and the actual overhead cost, then you can either charge the difference to the cost of goods sold (for smaller variances) or prorate the difference between the cost of goods sold and inventory.
What is Normal Costing? Normal costing is designed to yield product costs that do not contain the sudden cost spikes that can occur when you use actual overhead costs; instead, it uses a smoother long-term estimated overhead rate. It is acceptable under generally accepted accounting principles and international financial reporting standards to use normal costing to derive the cost of a product. Normal costing varies from standard costing, in that standard costing uses entirely predetermined costs for all aspects of a product, while normal costing uses actual costs for the materials and labor components.
Other Definitions Normal costing uses a predetermined annual overhead rate to assign manufacturing overhead to products. In other words, the overhead rate under normal costing is based on the expected overhead costs for the entire accounting year and the expected production volume for the entire year. Under actual costing each month s actual costs and each month s actual production volume are used to assign overhead costs. Since most companies will experience month to month fluctuations in activity, the actual monthly overhead rates will likely vary from month to month. Normal costing will result in an overhead rate that is more uniform and realistic for all of the units manufactured during an accounting year.
MOH = definition Manufacturing overhead (also referred to as factory overhead, factory burden, and manufacturing support costs) refers to indirect factory-related costs that are incurred when a product is manufactured. Along with costs such as direct material and direct labor, the cost of manufacturing overhead must be assigned to each unit produced so that Inventory and Cost of Goods Sold are valued and reported according to generally accepted accounting principles (GAAP). Manufacturing overhead includes such things as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, factory supplies and factory personnel (other than direct labor). How these costs are assigned to products has an impact on the measurement of an individual product's profitability.
MOH = definition Nonmanufacturing costs (sometimes referred to as administrative overhead ) represent a manufacturer s expenses that occur apart from the actual manufacturing function. In accounting and financial terminology, the nonmanufacturing costs include Selling, General and Administrative (SG&A) expenses, and Interest Expense. Since accounting principles do not consider these expenses as product costs, they are not assigned to inventory or to the cost of goods sold. Instead, nonmanufacturing costs are simply reported as expenses on the income statement at the time they are incurred.
Manufacturing Overhead On financial statements, each product must include the costs of the following: Direct material Direct labor Manufacturing (or factory) overhead According to generally accepted accounting principles (GAAP), manufacturing overhead must be included in the cost of Work in Process Inventory and Finished Goods Inventory on a manufacturer s balance sheet, as well as in the Cost of Goods Sold on its income statement
Manufacturing Overhead As their names indicate, direct material and direct labor costs are directly traceable to the products being manufactured. Manufacturing overhead, however, consists of indirect factoryrelated costs and as such must be divided up and allocated to each unit produced. For example, the property tax on a factory building is part of manufacturing overhead. Although the property tax covers an entire year and appears as one large amount on just one tax bill, GAAP requires that a portion of this amount be allocated or assigned to each product manufactured during that year.
Examples: Material handlers (forklift operators who move materials and units). People who set up the manufacturing equipment to the required specifications. People who inspect products as they are being produced. People who perform maintenance on the equipment. People who clean the manufacturing area. People who perform record keeping for the manufacturing processes. Factory management team. Electricity, natural gas, water, and sewer for operating the manufacturing facilities and equipment. Computer and communication systems for the manufacturing function. Repair parts for the manufacturing equipment and facilities. Supplies for operating the manufacturing process. Depreciation on the manufacturing equipment and facilities. Insurance and property taxes on the manufacturing equipment and facilities. Safety and environmental costs.
Steps for Analysis Cost Driver allocation base (cause-and-effect relationship) It can be direct machine or labor hours Calculating the application rate Recording Actual Overhead Costs Allocating OH to WIP Over and Under applied Overhead
Over Under applied: If variance is immaterial: directly allocated to COGS If variance is material: allocated based on relative values of WIP, Finished goods, COGS
Activity-Based Costing Indirect costs are attached to activities rather than simply dumped in one or two indirect cost pools More accuracy and greater detail regarding OH More complex and costly to implement
Examples Page 194 Extended examples
SU 6.4 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques Budgeted Budgeted Nash Glassworks Company has budgeted fixed manufacturing overhead of $100,000 per month. The company uses absorption costing for both external and internal financial reporting purposes. Budgeted overhead rates for cost allocations for the month of April using alternative unit output denominator levels are shown in the next column. Denominator Level Overhead Capacity Levels (units of output) Cost Rate Theoretical 1,500,000 $0.07 Practical 1,250,000 0.08 Normal 775,000 0.129 Master-budget 800,000 0.125 Actual output for the month of April was 800,000 units of glassware.
SU 6.4 Question 1 (continued) A. Normal capacity. B. Expected annual activity. C. Theoretical capacity. D. Master-budget capacity.
SU 6.4 Question 1 Answer Correct Answer: C Theoretical (ideal) capacity is the maximum capacity given continuous operations with no holidays, downtime, etc. It assumes perfect efficiency at all times. Consequently, it can never be attained and is not a reasonable estimate of actual volume. Incorrect Answers: A: Normal capacity is the long-term average level of activity that will approximate demand over a period that includes seasonal, cyclical, and trend variations. B: Expected annual activity is an approximation of actual volume levels for a specific year. D: Master-budget capacity is the expected level of activity used for budgeting for a given year.
A. SU 6.4 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques Annual overhead application rates are used to Budget overhead. B. C. D. Smooth seasonal variability of overhead costs. Simulate seasonal variability of activity levels. Treat overhead as period costs.
SU 6.4 Question 2 Answer Correct Answer: B Incorrect Answers: A: Overhead must be budgeted before a rate can be calculated. C: Overhead application rates are used to smooth seasonal variability of overhead costs. D: An overhead rate applies overhead to the product.
SU 6.5 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques Pane Company uses a job costing system and applies overhead to products on the basis of direct labor cost. Job No. 75, the only job in process on January 1, had the following costs assigned as of that date: direct materials, $40,000; direct labor, $80,000; and factory overhead, $120,000. The following selected costs were incurred during the year:
SU 6.5 Question 1 (continued) Traceable to jobs: Direct materials $178,000 Direct labor 345,000 Total $523,000 Not traceable to jobs: Factory materials and supplies $46,000 Indirect labor 235,000 Plant maintenance 73,000 Depreciation on factory equipment 29,000 Other factory costs 76,000 Total $459,000
SU 6.5 Question 1 (continued) Pane s profit plan for the year included budgeted direct labor of $320,000 and overhead of $448,000. Assuming no work-in-process on December 31, Pane s overhead for the year was A. $11,000 overapplied. B. $24,000 overapplied. C. $11,000 underapplied. D. $24,000 underapplied.
SU 6.5 Question 1 Answer Correct Answer: B Pane applies overhead to products on the basis of direct labor cost. The rate is 1.4 ($448,000 budgeted OH $320,000 budgeted DL cost). Thus, $483,000 ($345,000 actual DL cost 1.4) of overhead was applied, of which $24,000 ($483,000 $459,000 actual OH) was overapplied. Incorrect Answers: A: The amount of $11,000 equals the difference between budgeted and actual overhead. C: The amount of $11,000 equals the difference between budgeted and actual overhead. D: The overhead was overapplied.
SU 6.5 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques During the current accounting period, a manufacturing company purchased $70,000 of raw materials, of which $50,000 of direct materials and $5,000 of indirect materials were used in production. The company also incurred $45,000 of total labor costs and $20,000 of other manufacturing overhead costs. An analysis of the work-in-process control account revealed $40,000 of direct labor costs. Based upon the above information, what is the total amount accumulated in the overhead control account? A. $25,000 B. $30,000 C. $45,000 D. $50,000
SU 6.5 Question 2 Answer Correct Answer: B Overhead consists of all costs, other than direct materials and direct labor, that are associated with the manufacturing process. The overhead control account should have the following costs: Indirect materials $ 5,000 Indirect labor ($45,000 $40,000) 5,000 Other overhead 20,000 Total overhead $30,000
SU 6.5 Question 2 Answer (continue) Incorrect Answers: A: The amount of $25,000 excludes the indirect materials. C: The amount of $45,000 is the total labor cost. D: The amount of $50,000 is the direct materials cost.
Service Department Costs Direct Method Step-Down Method Reciprocal Method Single-rate Vs. Dual-Rate Allocation
Key concepts: Service Depart. = OH = not traced to cost object = must be allocated to operating Departs. Cause-&-effect relationship and/or benefits received Review examples Page 128 #3.7
Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques In allocating factory service department costs to producing departments, which one of the following items would most likely be used as an activity base? SU 6.6 Question 1 A. Units of product sold. B. Salary of service department employees. C. Units of electric power consumed. D. Direct materials usage.
SU 6.6 Question 1 Answer Correct Answer: C Service department costs are considered part of factory overhead and should be allocated to the production departments that use the services. A basis reflecting cause and effect should be used to allocate service department costs. For example, the number of kilowatt hours used by each producing department is probably the best allocation base for electricity costs. Incorrect Answers: A: Making allocations on the basis of units sold may not meet the cause-and-effect criterion. B: The salary of service department employees is the cost allocated, not a basis of allocation. D: Making allocations on the basis of materials usage may not meet the cause-and-effect criterion.
SU 6.6 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques When allocating costs from one department to another, a dual-rate costallocation method may be used. The dual-rate cost-allocation method is most useful when A. B. Two or more cost pools are to be allocated. Two or more departments costs are to be allocated. C. Two or more products are produced. D. Costs are separated into variable-cost and fixed-cost subpools.
SU 6.6 Question 2 Answer Correct Answer: D The dual-rate method of allocating costs from one department to another involves classifying the costs to be allocated into two pools, one variable and one fixed. Incorrect Answers: A: The dual-rate method is used with exactly two cost pools, one for fixed costs and one for variable costs. B: Use of the dual-rate depends on cost behavior, not the number of departments. C: Use of the dual-rate depends on cost behavior, not the number of products.