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Question: The primary focus of activity-based costing thus far has been on allocating manufacturing overhead costs to products. Although this is important for external reporting purposes, we can expand ABC to include costs beyond manufacturing overhead. Also, we can organize costs in different ways to help managers evaluate performance. What different approaches can be used to organize cost data in a way that helps managers make better decisions? Answer: Cost data can be organized in a number of ways to help managers make decisions. Four common approaches are addressed in this section:
External Reporting and Internal Decision MakingQuestion: U.S. Generally Accepted Accounting Principles require the allocation of all manufacturing costs to products for inventory costing purposes. The choice of an allocation method is not critical to this process. Companies that use direct labor hours, machine hours, activity-based costing, or some other method to allocate overhead costs to products are likely to be in compliance with U.S. GAAP. Throughout this chapter, we have illustrated how ABC is used to allocate manufacturing overhead costs. However, organizations often use ABC for purposes that go beyond allocating costs solely for external reporting. How might ABC be used to help companies in areas other than external reporting? Answer: Commissions paid to sales people for the sale of specific products (often called selling, general, and administrative) are included as an operating expense in financial reports prepared for external users as required by U.S. GAAP. However, many organizations may assign commission costs to specific products for internal decision-making purposes. This treatment is not in compliance with U.S. GAAP, but it is perfectly acceptable for internal reporting purposes and may be done using activity-based costing. It is important to understand that managers have ultimate control over which costs should be allocated to products for internal reporting purposes, and this allocation often involves going beyond overhead costs. Table 3.1 "Examples of Costs Allocated to Products" provides examples of costs that could be allocated to products. It also includes cost categories—product, selling, and general and administrative (G&A)—and indicates whether the cost allocation complies with U.S. GAAP for external reporting. As you can see in the far right column, all costs can be allocated to products for internal reporting purposes. Table 3.1 Examples of Costs Allocated to Products
Allocating Service Department Costs Using the Direct MethodQuestion: Most companies have departments that are classified as either service departments or production departments. Service departmentsDepartments that provide services to other departments within a company. provide services to other departments within the company and include such functions as accounting, human resources, legal, maintenance, and computer support. Production departmentsDepartments directly involved with producing goods or providing services for customers. are directly involved with producing goods or providing services for customers and include such functions as ordering materials, assembling products, and performing quality inspections. Why do companies often allocate a share of service department costs to production departments for internal reporting purposes even though U.S. GAAP generally does not allow it for external reporting? Answer: Companies allocate service department costs to production departments for several reasons:
Question: How do companies allocate service department costs to production departments and how might this be done at SailRite? Answer: Several methods of allocating service department costs to production departments are available. We introduce the simplest approach—the direct method—here (complex approaches are presented in more advanced cost accounting texts). The direct methodA method of allocating costs that allocates service department costs directly to production departments but not to other service departments. allocates service department costs directly to production departments but not to other service departments. For example, assume that SailRite Company has two service departments—Human Resources and Computer Support. Costs associated with Human Resources and Computer Support total $90,000 and $150,000, respectively. Recall that SailRite has two production departments—Hull Fabrication and Assembly. The goal is to allocate service department costs to the two production departments, as shown in Figure 3.10 "Allocating Service Department Costs to Production Departments at SailRite Company: Direct Method (Before Allocations)". Figure 3.10 Allocating Service Department Costs to Production Departments at SailRite Company: Direct Method (Before Allocations) SailRite would like to allocate service department costs using an allocation base that drives these costs. Assume management decides to use the number of employees as the allocation base to allocate Human Resources costs, and the number of computers as the allocation base to allocate Computer Support costs. Allocation base activity for each production department is as follows:
The allocation rate for human resource services is $750 per employee (= $90,000 department costs ÷ 120 employees). The allocation rate for computer support services is $2,000 per computer (= $150,000 ÷ 75 computers). Thus the Hull Fabrication department receives an allocation of $26,250 in human resource costs (= 35 employees × $750 rate) and $84,000 in computer support costs (= 42 computers × $2,000 rate). The Assembly department receives an allocation of $63,750 in human resource costs (= 85 employees × $750 rate) and $66,000 in computer support costs (= 33 computers × $2,000 rate). The allocations to production departments are shown in Figure 3.11 "Allocating Service Department Costs to SailRite’s Production Departments: Direct Method (After Allocations)". If management chooses to allocate service department costs to production departments as described here, there must be some benefit to going through the process. Should these costs be assigned to activity cost pools for the purpose of costing products (activity-based costing)? Should production department managers be evaluated based on the use of these services? Should actual service department usage be compared to budgeted usage for each production department? The answers to these questions vary from one organization to the next. However, one point is certain—the benefits of implementing this allocation system must outweigh the costs! Figure 3.11 Allocating Service Department Costs to SailRite’s Production Departments: Direct Method (After Allocations) The Hierarchy of CostsQuestion: Some organizations group activities into four cost categories, called the hierarchy of costs, to help managers form cost pools for activity-based costing purposes. The cost hierarchyA method of costing that groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level.Credit for developing the cost hierarchy is generally given to R. Cooper and R. S. Kaplan, “Profit Priorities from Activity-Based Costing,” Harvard Business Review, May 1991, 130–35.groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level. What is the difference between each of these categories, and how does this information help managers? Answer: Each category within the cost hierarchy is described as follows:
The cost hierarchy serves as a framework for managers to establish cost pools and determine what drives the change in costs for each cost pool. It also provides a sense of how quickly (or slowly) costs change based on decisions made by management. Examples of activities often identified by companies using activity-based costing, and how these activities fit in the cost hierarchy, appear in Table 3.2 "Cost Hierarchy Examples". Table 3.2 Cost Hierarchy Examples
Measuring the Costs of Controlling and Improving QualityQuestion: The hierarchy of costs is not the only approach organizations use to group costs. Managers are also concerned about measuring the costs associated with quality. Quality-related costs can be organized into four categories. The first two categories—prevention and appraisal—are costs incurred to control and improve quality. The final two categories—internal failure and external failure—are costs incurred as a result of failing to control and improve quality. What is the difference between these cost categories, and how does this information help managers improve quality?
Companies that measure these costs of quality typically calculate the costs in each category as a percent of total revenue. The goal is to steadily shift costs toward the prevention and appraisal categories and away from the internal and external failure categories. As organizations concentrate more on preventing defects, total quality costs as a percent of revenue tends to decline and product quality improves. Table 3.3 "Summary of Quality Costs" provides a summary of the four classifications of quality-related costs. Table 3.3 Summary of Quality Costs
Key Takeaway
Review Problem 3.6Fill in the following table to identify if the cost item can be included in the cost of products for external reporting purposes and/or internal reporting purposes. The first item is completed for you.
Solution to Review Problem 3.6
End-of-Chapter ExercisesQuestions
Brief Exercises
Exercises: Set A
Exercises: Set B
Problems
One Step Further: Skill-Building Cases
Comprehensive Case
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