Cost Accounting Allocation of Overhead MB664 May 2009

Cost Accounting Allocation of Overhead MB-664 May 2009

Managerial Cost Concepts 1. Direct materials: materials raw materials physically associated with the final product 2. Direct labor: labor employees physically and directly associated with the final product 3. Overhead: Overhead variable manufacturing overhead tied directly to the final product while fixed manufacturing overhead is not. 4. Selling and administrative: administrative Marketing expenses, office expenses and managerial salaries and benefits.

Budgets and Financial Statements Sales Budget Production Budget Direct Materials Budget Direct Labor Budget Overhead Budget Selling and Administrative Expense Budget Cash Budgeted Income Statement Budgeted Cash Flow Statement Capital expenditures Budgeted Balance Sheet

Enterprise Budgets and The Master Budget Enterprise #1 • Unit sales and expected price • Unit production and inventory • Direct materials used • Direct labor used • Manufacturing overhead Sales Budget Production Budget Direct Materials Budget Enterprise #n • Unit sales and expected price • Unit production and inventory • Direct materials used • Direct labor used • Manufacturing overhead Direct Labor Budget Overhead Budget

Enterprise Budgets and The Master Budget Enterprise #1 • Unit sales and expected price • Unit production and inventory • Direct materials used • Direct labor used • Manufacturing overhead Sales Budget Production Budget Direct Materials Budget Enterprise #n • Unit sales and expected price • Unit production and inventory • Direct materials used • Direct labor used • Manufacturing overhead Direct Labor Budget Overhead Budget

Enterprise Budgets and The Master Budget Enterprise #1 • Unit sales and expected price • Unit production and inventory • Direct materials used • Direct labor used • Manufacturing overhead Examples of direct materials: • Purchase of corn. • Purchase of natural gas. • Purchase of other inputs used in the ethanol production process. Examples of manufacturing overhead: • Variable manufacturing overhead examples include utilities, repairs and maintenance. • Fixed manufacturing overhead examples include property taxes, rent, insurance premiums, depreciation and legal and professional charges.

Use of ABC Accounting 1. Identify and classify activities and allocate overhead to cost pools. 2. Identify cost drivers – correlation between driver and use. 3. Calculate overhead rates or ABC rates 4. Assign overhead costs to products – use of cost drivers. 5. Allocate overhead to individual products.

Activity Based Cost Allocation Overhead Costs

Activity Based Cost Allocation Overhead Costs Ordering and Receiving Materials Cost Pool Setting Up Machines Cost Pool Machining Cost Pool Assembly Cost Pool Inspecting and Testing Cost Pool These are activity cost pools Painting Cost Pool

Activity Based Cost Allocation Overhead Costs Activity cost pools: Ordering and Receiving Materials Cost Pool Setting Up Machines Cost Pool Machining Cost Pool Assembly Cost Pool Inspecting and Testing Cost Pool Painting Cost Pool # of Purchase orders # of Setups # of Machine hours # of Parts # of Tests # of Direct hours These are cost drivers

Activity Based Cost Allocation Overhead Costs Activity cost pools: Ordering and Receiving Materials Cost Pool Setting Up Machines Cost Pool Machining Cost Pool Assembly Cost Pool Inspecting and Testing Cost Pool Painting Cost Pool # of Machine hours # of Parts # of Tests # of Direct hours Cost drivers: # of Purchase orders # of Setups Products

Example of ABC Accounting Step 1: calculate the ABC Overhead rate: Activity Cost Pool Setting up machines Machining Inspecting Total Process overhead $300, 000 $500, 000 $100, 000 $900, 000 Driver activity 1, 500 setups 50, 000 hours 2, 000 inspection AB overhead rate $200/setup $10/hour $50/inspection Divide the process overhead by level of driver activity to calculate the ABC overhead rate.

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost Pool Cost driver Setting up machines Machining Inspecting # setups Hours # inspections Driver activity 1, 500 50, 000 2, 000 Product 1 Product 2 500 30, 000 500 1, 000 20, 000 1, 500 Allocate the activity levels to the 2 products. For example, 500 of the setups are associated with product 1.

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost Pool Cost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, 500 1, 000 Machining Hours 50, 000 30, 000 20, 000 Inspecting # inspections 2, 000 500 1, 500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines $300, 000 (33%) $100, 000 (67%) $200, 000 Machining $500, 000 (60%) $300, 000 (40%) $200, 000 Inspecting $100, 000 (25%) $25, 000 (75%) $75, 000 500/1, 500 x $300, 000 or 500 units x $200/setup

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost Pool Cost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, 500 1, 000 Machining Hours 50, 000 30, 000 20, 000 Inspecting # inspections 2, 000 500 1, 500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines $300, 000 (33%) $100, 000 (67%) $200, 000 Machining $500, 000 (60%) $300, 000 (40%) $200, 000 Inspecting $100, 000 (25%) $25, 000 (75%) $75, 000 1, 000/1, 500 x $300, 000 or 1, 000 x $200/setup

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost Pool Cost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, 500 1, 000 Machining Hours 50, 000 30, 000 20, 000 Inspecting # inspections 2, 000 500 1, 500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines $300, 000 (33%) $100, 000 (67%) $200, 000 Machining $500, 000 (60%) $300, 000 (40%) $200, 000 Inspecting $100, 000 (25%) $25, 000 (75%) $75, 000 30, 000/50, 000 x $500, 000 or 30, 000 x $10/hour

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost Pool Cost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, 500 1, 000 Machining Hours 50, 000 30, 000 20, 000 Inspecting # inspections 2, 000 500 1, 500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines $300, 000 (33%) $100, 000 (67%) $200, 000 Machining $500, 000 (60%) $300, 000 (40%) $200, 000 Inspecting $100, 000 (25%) $25, 000 (75%) $75, 000 20, 000/50, 000 x $500, 000 or 20, 000 x $10/hour

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost Pool Cost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, 500 1, 000 Machining Hours 50, 000 30, 000 20, 000 Inspecting # inspections 2, 000 500 1, 500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines $300, 000 (33%) $100, 000 (67%) $200, 000 Machining $500, 000 (60%) $300, 000 (40%) $200, 000 Inspecting $100, 000 (25%) $25, 000 (75%) $75, 000 500/2, 000 x $100, 000 or 500 x $50/inspection

Example of ABC Accounting Step 2: Assigning overhead driver activity to products: Activity Cost Pool Cost driver Driver Product 1 Product 2 activity Setting up machines # setups 1, 500 1, 000 Machining Hours 50, 000 30, 000 20, 000 Inspecting # inspections 2, 000 500 1, 500 Step 3: Partitioning of process overhead: Overhead Product 1 Product 2___ Setting up machines $300, 000 (33%) $100, 000 (67%) $200, 000 Machining $500, 000 (60%) $300, 000 (40%) $200, 000 Inspecting $100, 000 (25%) $25, 000 (75%) $75, 000 1, 500/2, 000 x $100, 000 or 1, 500 x $50/inspection

Example of ABC Accounting Step 3: Partitioning of process overhead: Overhead Product 1 Setting up machines $300, 000 $100, 000 Machining $500, 000 $300, 000 Inspecting $100, 000 $25, 000 Total $900, 000 $425, 000 Step 4: Process overhead costs per unit: Units produced 25, 000 Process overhead cost per unit $17 Product 2 $200, 000 $75, 000 $475, 000 $95 $17 = $425, 000 / 25, 000 $95 = $475, 000 / 5, 000

Example of ABC Accounting Step 3: Partitioning of process overhead: Overhead Product 1 Setting up machines $300, 000 $100, 000 Machining $500, 000 $300, 000 Inspecting $100, 000 $25, 000 Total $900, 000 $425, 000 Product 2 $200, 000 $75, 000 $475, 000 Step 4: Process overhead costs per unit: Units produced 25, 000 Process overhead cost per unit $17 5, 000 $95 Traditional process overhead cost per unit $30 $30 = $900, 000 / (25, 000 + 5, 000)

Example of ABC Accounting Product 1 Product 2 COP unit costs with ABC costing: Direct materials Direct labor ABC manufacturing overhead Total unit costs $40 $12 $17 $69 $30 $12 $95 $137 COP unit costs with traditional costing: Direct materials Direct labor Traditional manufacturing overhead Total unit costs $40 $12 $30 $82 $30 $12 $30 $72 Traditional overhead costing suggests that Product 2 is cheaper to produce than Product 1, which is not true!