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Cost Accounting

Management 122
Michael Williams

Overhead Allocation
Overhead costs must be assigned to cost
objects such as products or divisions.
To simplify the process, companies lump
overhead items together into a small number
of cost pools, often only one.
The cost pools are assigned to cost objects in
proportion to allocation bases, such as direct
materials cost or direct labor hours used.

Example:
Cost Pool A includes $20,000 of overhead
costs.
Cost Pool As allocation base is direct labor
hours.
Product X uses 200 labor hours.
Product Y uses 300 labor hours
Allocate $20,000 x 200 / (200+300) =
$8,000 to X.

Types of Cost Objects


The nature of cost allocation is similar for different types.
Jobs: Each product is unique and needs to be accounted
for separately. Example: audits.
Processes: A series of identical products are made. The
individual products do not need separate accounting.
Example: cars.
Departments: A sub-unit of the company that performs
specific tasks. Often, we need to assess departmental
performance so need to know its costs.

Strategies in Overhead
Allocation
How many cost pools should a firm use?
Many pools:
More flexibility in allocation bases.

Few pools:
Less costly accounting.

Cost Driver:
The underlying cause of a particular cost.

Strategies in Overhead Allocation


continued:

Example:

Cost
Machine maintenance
Human resource
department
Plant rent

Choice of allocation base:


Fantasy
Reality

Cost driver
Machine hours used
Direct labor hours
?

Use cost driver


Cost driver not
measurable

Try to find a good proxy to the cost driver. Maximize


correlation.

Estimation
Since we generally cant allocate costs using cost
drivers, there is imperfect fit between the allocation
and the true cost.
In practice, we must guess in advance how much cost
to expect per unit of the allocation base. We need to
see a predetermined allocation rate.
Example: We forecast overhead costs for a plant at
$300,000 for the next month, with 20,000 direct labor
hours. We would set an allocation rate of 300,000 /
20,000 = $15 per labor hour.

Correction
Forecasts are never accurate. Particularly when cost drivers are
not used for allocation, we will ultimately allocate more or less
cost than actually incurred.
We need to fix the errors at the end of accounting period by
adding or subtracting overhead to cost objects to restore balance.
Example: Refer to the prior example. At the end of the month,
actual overhead is $352,000 and actual labor hours are 22,000.
Since the predetermined rate was $15 per hour, we allocated
$330,000 of overhead, leaving $22,000 of actual overhead
unallocated.
We can fix the problem by allocating an extra $1 of overhead per
labor hour.

Activity Based Costing What?


ABC is a methodology for selecting cost pools
and allocation bases.
ABC is a systematic, relatively modern approach.
It involves multiple pools, each associated with
an important production activity.
Allocation bases are selected to correspond to
the cost drivers of the key activities.

Activity Based Costing


Why?

ABC seeks to provide cost allocations that are closer to true


economic costs.
This aids decision making.

By focusing on key activities, collecting and utilizing detailed


information about them, it enables better control of the
production process.
The downside of ABC is the added complexity and
implementation cost of the system.
Unless the information is effectively used by management, ABC
is a waste of resources.

Activity Based Costing How?


Review the steps involved in providing a product.
Identify the most important activities involved in the
process.
Associate every overhead cost with one of those key
activities. Create a cost pool for each activity.
Determine the cost driver of each activity generally the
volume of the activity itself.
Determine how to measure the cost drivers establish an
allocation base for each activity.

Cost Hierarchy
The key activities should be representative of all the
activities that generate overhead costs.
One way to ensure sufficient diversity is to sort activities
into a hierarchy. Key activities should be chosen from all
levels in the hierarchy that are significant to the business.
The highest level in the hierarchy involves the biggest
decisions, in particular setting up the firm to be able to do
things. The lowest level deals with production of individual
units of output.
Not every level is important in every company.

Cost Hierarchy
Category

Example

Capacity

Depreciation

Product

Product specifications

Customer

Billing

Batch

Machine setup

Unit

Electricity

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