ACCT6004 Management Accounting: Direct and Indirect Costs, Cost Allocation Activity Based Costing and Management

ACCT6004 Management Accounting
Module 2
Direct and Indirect Costs, Cost
Allocation
Activity Based Costing and
Management
3/14/21
Chapter 3
Direct and Indirect Costs, and

Cost Allocation
Laureate International Universities®

Learning Objectives
At the end of Chapter 3, you should be able to
• Differentiate between direct and indirect costs.
• Outline the process of indirect cost allocation:
support departments vs producing departments
• Assign support department costs to producing
departments, using the:
– direct
– sequential, and
– reciprocal methods

3
Cost Behaviour
• Cost behaviour is the variation in costs relative to the
variation in an organisation’s activities
• Ability to analyse cost behaviour requires knowledge
of an organisation’s economic environment and
operations
• Costs can be categorised by how they are used in
decision making
• Costs can also be distinguished by the way they
change as activity or volume levels change

4
Cost Objects
• A cost object is anything for which a separate
measurement of cost is desired
Business units
Geographic regions Services

Costs in
accounting
information
Customers system Product
Departments
Business processes
5
Direct and Indirect Costs
• The need for information will determine the cost
object that is the focus for cost collection
• When calculating the total cost for any cost object it
is necessary to identify
– Direct costs
– Indirect costs

6
Direct Costs
• Direct costs have a cause-and-effect relationship with
cost object
Direct cost Cost object

• A cost/benefit test will assess the cost of tracing cost
to cost objects against benefits of having more
detailed cost information tracing system

7
Indirect Costs
• Indirect costs are used for the benefit of many cost
objects and cannot be easily related to any specific
cost object
Cost object A
Indirect cost Cost object B
Cost object C

8
Direct or Indirect Cost Classification
• Whether a cost is classified as direct or indirect
depends on the
– Specific cost object which is being analysed
– Cost/benefit assessment of tracing the cost

9
• Your sister turned her hobby into a small
business called Glazed Over. She is a potter
and manufactures and sells bowls that can be
used for decoration or for birdbaths. She has
one employee who works 40 hours a week no
matter how many bowls are made. She has
asked your advice in analysing her costs for
product costing purposes.

Required: The following list of costs comes from
your sister’s general ledger. Assuming the cost
object is an individual unit (i.e. bowl),
categorise each cost as direct or indirect.

10
(a) Employee wages
(b) Clay used to make bowls
(c) Depreciation on the kilns
(d) Glaze (the finish painted on the bowls)
(e) Brushes for the glaze
(f) Electricity
(g) Business licence
(h) Advertising
(i) Pottery studio maintenance (cost of weekly
cleaning service)
(j) Packing materials for the bowls

11
(a) Employee wages (D or I)
(b) Clay used to make bowls (D)
(c) Depreciation on the kilns (I)
(d) Glaze (the finish painted on the bowls) (D or I)
(e) Brushes for the glaze (I)
(f) Electricity (I)
(g) Business licence (I)
(h) Advertising (I)
(i) Pottery studio maintenance (cost of weekly
cleaning service) (I)
(j) Packing materials for the bowls (D or I)

12
Indirect Cost Allocation
• Cost allocation refers to the allocation of indirect
costs to specific cost objects
• Allocation of indirect costs
– Enables determination of the full cost of cost
object
– Allocates cost of shared services
– Encourages use of central services
– Helps control costs by mutual monitoring
– Complies with external requirements

13
Cost Drivers
• A cost driver provides a measure of activity that
explains the cost object’s use of the indirect cost
• Criteria used to select appropriate cost drivers
include
– Cause and effect
– Benefits received
– Fairness or equity
– Ability to bear
– Behavioural factors

14
Cost Drivers (cont’d)
• Cost drivers can be classified as
– Volume drivers, or
– Activity drivers
• Volume drivers use a measure of output to assign
indirect costs
– e.g. labour hours, units of output
• Activity drivers are factors that relate to attributes of
individual activities and recognise causal factors
other than volume

15
Determining the Allocation Rate
Steps in allocation process
1. Develop the cost allocation formula
– Identify indirect costs to be allocated
– Select appropriate cost driver
2. Calculate the indirect cost rate
– Divide indirect costs by total cost driver usage
3. Allocate cost to the cost object
– Calculated by multiplying indirect cost rate by cost
object’s use of cost driver

16
Determining the Allocation Rate (cont’d)
• To start the allocation process, entity must decide on
number of indirect cost pools
• A cost pool is a grouping of similar individual costs on
a departmental or some other basis
• An allocation formula is developed for each cost pool
• An indirect cost rate is used to assign the cost to the
cost object

17
Determining the Allocation Rate (cont’d)
• Determination of an actual indirect cost rate is not
possible until the end of the period
• To avoid delay and also monthly fluctuations in cash
flows, entity may use a predetermined indirect cost
rate based on budgeted costs
• This provides a benchmark against which to measure
actual costs
• As the number of cost pools increases, the accuracy
of cost information increases

18
A Costing Framework
Simple costing system to determine full cost of a cost
object
Indirect cost
Allocated via
cost driver
Cost object
Trace via source
documentation
Direct cost

19
Apply the Costing Framework in Support
Department Setting
• Support departments provide internal services to
other departments
Steps in allocation process
1. Clarify purpose of allocation
2. Identify support and operating department cost pools
3. Assign costs to cost pools
4. Choose allocation base for each support
department cost pool
5. Choose and apply allocation method

20
Apply the Costing Framework in Support
Department Setting (cont’d)
Individual
units of
Support department goods or
cost pool A services
Operating department
cost pool Y
Support department
cost pool B
Individual
Operating department units of
cost pool Z goods or
services
Support department
cost pool C

21
Allocation Methods
Three methods are commonly used to allocate support
department costs to operating departments
– Direct method
– Step-down method
– Reciprocal method

22
Direct Method
• Allocates cost of each support department only to
operating departments
Medical patient
visits
Medical
Administration department
cost pool
Dental patient
Dental visits
Housekeeping department
cost pool

23
Direct Method: Example
Cost object, cost pools and assigning costs
Cost Administration Housekeeping Medical Dental Total
Salaries $80 000 $40 000 $200 000 $80 000 $400 000
Supplies 15 000 20 000 35 000 10 000 80 000
Facility costs 3 240 360 28 800 3 600 36 000
Total $98 240 $60 360 $263 800 $93 600 $516 000
Choosing allocation bases

Administration Housekeeping Medical Dental Total
No. of
employees 2 2 5 3 12
Sq. metres 900 100 8 000 1 000 10 000

24
Direct Method: Example (cont’d)
Support Production
Allocation bases
Sq. metres 8 000 1 000 9 000
89% 11% 100%
No. of employees 5 3 8
62.5% 37.5% 100%
Costs
Department cost $98 240 $60 360 $263 800 $ 93 600 $516 000
Housekeeping (60 360) 53 720 6 640 0
Administration (98 240) 61 400 36 840 0
Total allocated . costs $ 0
$ 0 $378 920 $137 080 $516 000

25
Step-down Method
• Allocates support department costs, one department
at a time, to remaining support and operating
departments in a cascading manner until all support
departments have been allocated
Steps
1. Allocate costs of support department providing
biggest percentage of services
2. Allocate costs of last support department

26
Step-down Method (cont’d)
Step 1: Allocate costs of support department providing
biggest percentage of services
Support departments
Housekeeping
Administration Operating departments

Medical
department
cost pool
Dental
department
cost pool
27
Step-down Method (cont’d)
Step 2: Support department costs are allocated
sequentially
Medical patient
Operating departments visits
Medical
department
cost pool
Housekeeping
Dental Dental patient
department visits
cost pool

28
Step-down Method: Example
Support Production
Allocation bases
No. of employees 2 5 3 10
(2/10) (5/10) (3/10)
20% 50% 30% 100%
Sq. metres 8 000 1 000 9 000
(8000/9000) (1000/9000)
89% 11% 100%
Costs
Department cost $98 240 $60 360 $263 800 $ 93 600 $516 000
1.Administration (98 240) 19 648 49 120 29 472 0
2.Housekeeping 0 (80 008) 71 207 8 801 0
Total allocated . costs $ 0
$ 0 $384 127 $131 873 $516 000

29
Reciprocal Method
• Simultaneously allocates costs among support
departments, and then to operating departments
• Reflects support department interactions more
accurately than other methods
Steps
1. Simultaneously allocate support department
costs among support departments
2. New total for each support department
allocated to all other departments

30
Reciprocal Method (cont’d)
Step 1: Simultaneously allocate support department costs
among support departments
Administration Housekeeping

31
Reciprocal Method (cont’d)
Step 2: Allocate total costs from Step 1 to all
departments
Medical patient
visits
Medical
Administration department
cost pool
Dental patient
Dental visits
Housekeeping department
cost pool

32
Reciprocal Method: Example
1. Simultaneously allocate support department costs to each
other
Housekeeping = $60 360 + 0.20(Administration)
Administration = $98 240 + 0.09(Housekeeping)
Substituting for A in H
H = $60 360 + 0.2*($98 240 + 0.09*H)
H = $60 360 + $19648 + 0.018*H
H = $81 475
Substituting in A
A = $98 240 + 0.09*$81 475
A = $105 573

33
Reciprocal Method: Example
2. Allocate total costs to all departments
Support Production
Allocation bases
Sq. metres 900 8 000 1 000 9 900
9% 81% 10% 100%
No. of employees 2 5 3 10
20% 50% 30% 100%
Costs
Department cost $98 240 $60 360 $263 800 $ 93 600 $516 000
Housekeeping 7 333 (81 475) 65 995 8 147 0
Administration (105 573) 21 115 52 786 31 672 0
Total allocated costs
. $ 0
$ 0 $382 581 $133 419 $516 000

34
Comparing Direct, Step-down and
Reciprocal Methods
• Direct method is the easiest to calculate
• But computer programs reduce importance of this
factor
• Direct and step-down easier to explain to managers
• Reciprocal method most accurately considers support
department interactions

35
Direct, Step-down and Reciprocal Methods:
Compare Results and Choose a Method
Comparing the results
Medical Dental Total
Direct method $378 920 $137 080 $516 000
Step-down method 384 127 131 873 516 000
Reciprocal method 382 581 133 419 516 000
Average cost per patient visit

Medical Dental
No. of patient visits 12 000 10 000
Direct method $31.58 $13.71
Step-down method 32.01 13.19
Reciprocal method 31.88 13.34
36
Limitation of Cost Allocation Data
Allocation cost involves uncertainties
• Identifying appropriate cost pools
• Deciding whether to establish separate cost pools for
fixed and variable costs
• Assigning costs to cost pools
• Identifying appropriate allocation bases
• Selecting most appropriate method
• Determining cost-benefit relationship

37
Chapter 10
Activity Based Costing and Management

38
Learning Objectives
At the end of Chapter 10, you should be able to:
• Distinguish between activity-based costing
(ABC) and conventional costing systems
• Explain why traditional costing approaches
may cause cost distortion
• Analyse why ABC system produces more
accurate product costs.
• Allocate costs using ABC system
• Explain ABC system and activity-based
management (ABM) approach
39
Activity-Based Costing (ABC) and
Conventional Costing
• Cost accounting systems have adapted over time to
suit changes in
– Operational environments
– Technology
– Cost structures
– Management reporting requirements
– Organisational structures, particularly those focusing
on the value chain

40
Conventional Cost Accounting Systems
Costs traced to individual product or service:
Direct materials
Direct labour
Costs allocated to individual product or service: Individual

Overhead costs Overhead cost pool products or
Indirect materials, Trace or Allocated using a services
Allocate
indirect labour, base such as labour
production facility allocate hours, labour costs or
costs, etc machine hours

41
Conventional Cost Accounting Systems (cont’d)
• Inappropriate pooling of indirect costs and poor
choices for cost drivers can lead to the incorrect costs
of products or services
• With multiple cost pools, conventional allocation
bases rarely reflect flow of resources to products of
different complexity

42
Activity-based Costing Systems
• ABC is a system that assigns overhead costs to specific
activities performed in a manufacturing or service
delivery process
• An activity is a type of task or function performed in
an organisation
• Costs of various activities become the building blocks
used to compile total costs for products or other cost
objects

43
Activity-based Costing Systems (cont’d)
• Multiple cost pools are used to reflect various
activities performed
• ABC focuses on the fundamental characteristic
driving cost pool identification and cost pool
selection
2 steps
1. Cost of overhead resources assigned to activity cost
pools
2. Activity costs allocated to individual products or
services

44
Activity-based Costing Systems (cont’d)
Costs traced to individual product or service:
Direct materials
Direct labour
Costs allocated to individual product or service:
Trace or Material handling
allocate activity cost pool Individual
Transport
Allocated using no. of Allocate products,
equipment costs
parts handled using services or
Inspection activity activity other cost
Supervisors’ objects
salaries cost pool cost
Allocated using no. of driver
units inspected
Inspectors’
salaries Other activity
cost pools
Other Allocated using
resource costs activity cost drivers
45
ABC Cost Hierarchy
Organisation-sustaining activities
• Undertaken to oversee entire entity
• Independent of number or types of facilities,
customers, products, batches, units
e.g. costs of corporate head office

46
ABC Cost Hierarchy (cont’d)
Facility-sustaining activities
• Undertaken to provide and manage an area, location
or property
• Independent of number of customers, products,
batches, units
e.g. research facility manager salary, building
depreciation, insurance, security, car parking

47
Customer-sustaining activities
• Undertaken to service past, current and future
customers
• Vary with needs of customer groups
Product-sustaining activities
• Undertaken to support production and distribution of
a single product or line of products

48
Batch-level activities
• Undertaken for a collection of goods or services
processed as a group
e.g. machinery set-up costs
Unit-level activities
• Undertaken to produce individual units manufactured
or services produced
e.g. direct material costs, direct labour costs

49
ABC: Implementation
Typical procedures
1.Identify the relevant cost object
2.Identify activities
3.Assign cost to activity-based cost pools
4.For each ABC cost pool, choose a cost driver
5.For each ABC cost pool, calculate a cost driver rate
6.For each ABC cost pool, allocate activity costs to the
cost object

50
An ABC Example
Assume the following activity costs were
incurred in the manufacturing of three product
lines (electronic products manufacturer):
1. Writing Test Programs $200,000
2. Making Circuit Boards 120,000
3. Setting-up Insert Machine 175,000
4. Inserting Components 100,000
5. Providing Space 50,000
6. Utility Cost 130,000
Total $775,000

51
An ABC Example (Continued)
Operational Data
Product Product Product

Possible Drivers Line 1 Line 2 Line 3
Units produced 100,000 200,000 150,000
Number of orders 200 300 600
Number of tests 500 200 1,000
Machine hours 5,000 6,000 4,000
Products/models 150 50 200
Square feet of space 5,000 7,000 6,000
Direct labor hours 2,000 3,500 2,250

52
The ABC Model
1st Stage Allocation $775,000 Resource Drivers

(complete)
Writing Prog. Making /Ins. Setups Space/Util.

$200,000 $220,000 $175,00 $180,000
# Products Machine hours # Orders Square feet
2nd Stage
Activity
Allocation
Drivers
Product Product Product
Line 1 Line 2 Line 2

53
An ABC Example (Continued)
Cost Driver Activity Pool

Pool Level Amount Driver Rate
Writing Prog. Products $200,000 400 products $500/product
Making/Ins. Units 220,000 15,000 M. H. $14.67/M. H.
Setup Batch 175,000 1,100 orders $159.09/order
Space/Util. Facility $180,000 18,000 sq. feet $10/sq. foot

54
Unit Cost Calculation with ABC
Cost Product Product Product
Pool Line 1 Line 2 Line 3 Total
Writing Prog. $75,000 $25,000 $100,000 $200,000
Making/Ins. 73,350 88,020 58,630 220,000
Setup 31,818 47,727 95,455 175,000
Space/Util. 50,000 70,000 60,000 180,000
Total $230,168 $230,747 $314,085 $775,000
Unit Cost Product Line 1 $230,168/100,000 units = 2.30/unit
U nit Cost Product Line 2 $230,747/200,000 units = $1.15/unit
Unit Cost Product Line 3 $314,085/150,000 units = $2.09/unit

55
Unit Overhead Cost Using Conventional
Methods
Predetermined Overhead Rate Using Direct Labor Hours
Overhead Rate = $775,000/7,750 hours

= $100/direct labor hour
Unit Cost Product Line 1 (2,000 dlh x $100) = $200,000/100,000

= $2.00

= $1.75

= $1.50

56
Comparison of ABC and Conventional
Costing
Unit Cost ABC Unit Cost Conventional
Product Line 1 $2.30 $2.00
Conventional cost accounting tends to over-cost high volume products

and under-cost low volume items (note implications for product line 2.)

57
Activity-based Management (ABM)
• ABM is the process of using ABC information to
evaluate opportunities for improvements in an
organisation
• Four main uses of ABM
– Managing customer profitability
– Managing product and process design
– Managing environmental costs
– Managing constrained resources

58
Managing Customer Profitability
• ABC can be used to identify customer-sustaining
activities that cause some customers to be more
costly than others
• Managers can then choose different strategies for
different types of customers

59
Managing Product and Process
Improvement
• ABC allows managers to improve their understanding
of how resources are used
• Focus is on value-added activities
– Those activities for which the customer is prepared to
pay
• Reduce or eliminate non-value added activities
– Often associated with waste such as rework

60
Managing Environmental Costs
• The direct cost of reducing pollution is often easily
tracked
• However, with conventional accounting systems, it is
more difficult to identify costs and benefits of
protecting the environment
• ABC systems can be designed to
– Identify activities involved in environmental protection
– Develop costs for those activities

61
ABC Considerations
Benefits Costs
• More accurate • Systems design costs
product cost • Modification of
information accounting and
• Employees focus information systems to
attention on value- captured additional
added activities information
• Measurement of the • Employee training to
costs of activities and use ABC system
business processes effectively

62
ABC: Issues
Limitations and uncertainties in ABC implementation
• Judgment required when determining activities and
selecting cost drivers
• Denominator levels for cost drivers are estimates
• Response of employees to design and
implementation of ABC system

63
ABC: Issues (cont’d)
Mismeasurement of costs assigned to ABC activities
• Risk of measurement error increases
– If uncertainties exist about activity
– When costs are allocated instead of being traced
to ABC cost pool
– When number of ABC cost pools increases

64
ABC: Issues (cont’d)
Advantages of Limitations of
time-driven ABC time-driven ABC
• More informed decision • Calculations based on
making in relation to subjective and rule-of-thumb
availability and best use estimates
of practical capacity • May not capture the ‘value’
• Improved computer of time (all time assumed
equal)
costing systems capability
• May not differentiate
when using standard
expertise (and cost)
rates
• May not be suitable where
• Incorporation of overhead costs lack
complexity of operations homogeneity
in model
65

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ACCT6004 Management Accounting

Direct and Indirect Costs, and

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Geographic regions Services

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Direct cost Cost object

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Choosing allocation bases

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Administration Operating departments

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Average cost per patient visit

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Costs allocated to individual product or service: Individual

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Product Product Product

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1st Stage Allocation $775,000 Resource Drivers

Writing Prog. Making /Ins. Setups Space/Util.

# Products Machine hours # Orders Square feet

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Cost Driver Activity Pool

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Unit Cost Product Line 1 $230,168/100,000 units = 2.30/unit

U nit Cost Product Line 2 $230,747/200,000 units = $1.15/unit