Determine the dollar amount of the Janitorial Department costs to be allocated to the

We previously explained how to assign overhead costs to jobs (and processes) by using a predetermined overhead rate per unit of an allocation base such as direct labor cost. When a single overhead rate is used on a companywide basis, all overhead is lumped together, and a predetermined overhead rate per unit of an allocation base is computed and used to assign overhead to jobs (and processes). The use of a single predetermined overhead rate suggests that this allocation process is simple. In reality, it can be complicated. This chapter explains the traditional two-stage cost allocation procedure and then introduces the activity-based cost allocation procedure.

Point: Use of a single overhead allocation rate is known as using a plantwide rate.

First Stage   To illustrate the first stage of cost allocation, we use the janitorial department. Its costs are allocated to machining and assembly in the ratio 60:40. This means that 60%, or $6,000, of janitorial costs are assigned to the machining department and 40%, or $4,000, to the assembly department. The expenses incurred by the maintenance and factory accounting departments are similarly assigned to machining and assembly. We then add the expenses directly incurred by each operating department to these assigned costs to determine the total expenses for each operating department. This yields total costs of $25,000 for machining and $36,000 for assembly.

Point: Use of a separate overhead allocation rate for each department is known as using departmental rates.

Overhead Misled  Futura Computer outsourced a “money-losing” product to a Korean firm for manufacturing. Its own manufacturing facility was retooled to produce extra units of a “more profitable” product. Profits did not materialize, and losses grew to more than $20 million! What went wrong? It seems the better product was a loser and the losing product was a winner. Poor overhead allocations misled Futura’s management.

For companies with only one product, or with multiple products that use about the same amount of indirect resources, using a single overhead cost rate based on volume is adequate. Multiple overhead rates can further improve on cost allocations. Yet, when a company has many products that consume different amounts of indirect resources, even the multiple overhead rate system based on volume is often inadequate. Such a system usually fails to reflect the products’ different uses of indirect resources and often distorts products costs.

   Activity-based costing (ABC)Cost allocation method that focuses on activities performed; traces costs to activities and then assigns them to cost objects.  attempts to better allocate costs to the proper users of overhead by focusing on activities. Costs are traced to individual activities and then allocated to cost objects. Exhibit 21.3 shows the (two-stage) activity-based cost allocation method. The first stage identifies the activities involved in processing Jobs 236, 237, and 238 and forms activity cost pools by combining those activities. The second stage involves computing predetermined overhead cost rates for each cost pool and then assigning costs to jobs.

Point: Activity-based costing is used in many settings. A study found that activity-based costing improves health care costing accuracy, enabling improved profitability analysis and decision making. However, identifying cost drivers in a health care setting is challenging.

   We begin our explanation at the top of Exhibit 21.3. The first stage identifies individual activities, which are pooled in a logical manner into homogenous groups, or cost pools. A homogenous cost pool consists of activities that belong to the same process and/or are caused by the same cost driver. An activity cost driverVariable that causes an activity’s cost to go up or down; a causal factor., or simply cost driver, is a factor that causes the cost of an activity to go up or down. For example, preparing an invoice, checking it, and dispatching it are activities of the “invoicing” process and can therefore be grouped in a single cost pool. Moreover, the number of invoices processed likely drives the costs of these activities.

Point: A cost driver is different from an allocation base. An allocation base is used as a basis for assigning overhead but need not have a cause-effect relation with the costs assigned. However, a cost driver has a cause-effect relation with the cost assigned.

Director of Operations   Two department managers at your ad agency complain to you that overhead costs assigned to them are too high. Overhead is assigned on the basis of labor hours for designers. These managers argue that overhead depends not only on designers’ hours but on many activities unrelated to these hours. What is your response?

ABC uses more allocation bases than a traditional cost system. For example, a Chicago-based manufacturer currently uses nearly 20 different activity cost drivers to assign overhead costs to its products. Exhibit 21.6 lists common examples of overhead cost pools and their usual cost drivers.

ABC is especially effective when the same department or departments produce many different types of products. For instance, more complex products often require more help from service departments such as engineering, maintenance, and materials handling. If the same amount of direct labor is applied to the complex and simple products, a traditional overhead allocation system assigns the same overhead cost to both. With activity-based costing, however, the complex products are assigned a larger portion of overhead. The difference in overhead assigned can affect product pricing, make-or-buy, and other managerial decisions.

ABC encourages managers to focus on activities as well as the use of those activities. For instance, assume AutoGrand can reduce the number of transactions processed in Factory Accounting to 1,500 (375 transactions for Job 236, 525 transactions for Job 237, and 600 transactions for Job 238) and that through continuous improvement it can reduce costs of processing those transactions to $4,500. The resulting rate to process a transaction is $3 per transaction ($4,500/1,500 transactions—down from $4 per Exhibit 21.3). The cost of transaction processing is reduced for all jobs (Job 236, $1,125; Job 237, $1,575; Job 238, $1,800). However, if those accounting costs were grouped in a single overhead cost pool, it is more difficult to identify cost savings and understand their effects on product costs.

ABC requires managers to look at each item and encourages them to manage each cost to increase the benefit from each dollar spent. It also encourages managers to cooperate because it shows how their efforts are interrelated. This results in activity-based management.

Accounting Officer   Your company produces expensive garments, whose production involves many complex and specialized activities. Your general manager recently learned about activity-based costing (ABC) and asks your advice. However, your supervisor does not want to disturb the existing cost system and instructs you to prepare a report stating that “implementation of ABC is a complicated process involving too many steps and not worth the effort.” You believe ABC will actually help the company identify sources of costs and control them. What action do you take?