Road Map for the next 7 weeks

LONG-TERM DECISIONS
Capacity resources (buildings, equipment, skilled staff) are
fixed in the short term but can be adjusted in the long term
=> capacity costs are relevant for long-term decisions
=> need to think about capacity resources and capacity costs
(aka fixed costs) in making long-term decisions

Outline:
• Ch 9: cost allocations – making sense of capacity costs
• Ch 10: activity-based costing (ABC) – making even more
sense of capacity costs
• Ch 11: long-term investment decisions
• Ch 12: long-term performance evaluation
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• Ch 13: strategic planning and control
 Chapter 9

Cost Allocations
 Lecture Outline
• Cost allocation
 Basic allocation
 Refined allocation with multiple cost pools and drivers
• Using cost allocation for long-term decisions
 Keep or drop a product line?
 How is this analysis different from the short term?

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 Why do we care?
• Capacity costs (fixed costs) are HUGE:
about 40% of total costs in manufacturing,
>90% of total costs in many service industries
• Capacity costs are MESSY: cannot be traced to
individual product lines
• Cost allocations help us understand/predict
these costs => better long-term decisions

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 Main Complication: Shared Capacity Costs
RIP Mattress Company has two product lines: Standard and Deluxe.
Standard Deluxe Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing overhead $50,000
SG&A (selling, general & admin) 30,000
Profit $20,000

Shared capacity costs:

• cannot be traced to individual product lines
• a large fraction of total costs (40%) => we want to know:
(1) How can we divide them between Standard and Deluxe?
(2) How will they change with our long-term decisions?
5 We use cost allocation to answer these questions.
 Cost Allocation: General Idea
1. Find a cost driver that has a clear cause-and-effect relation
with the usage of capacity resources
Firm A is labor-intensive. The main capacity resources (buildings,
equipment, labor supervisors) support direct labor in the assembly of
the finished products. Choose the best cost driver:
 number of units produced
 machine hours
 direct labor hours
 number of different product lines

Firm B is machine-intensive. The capacity resources (buildings,

machines, maintenance staff) support automated production in
computer-controlled machines. Choose the best cost driver:
 number of units produced
 machine hours
 direct labor hours
 number of different product lines
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 Cost Allocation: General Idea
2. Allocate capacity costs to the product lines based on their use
of the cost driver

allocation rate = total capacity costs in the “cost pool”

total number of cost driver units

allocated costs for product line X =

= allocation rate × number of cost driver units for X

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 Example: Cost Allocation
Standard Deluxe Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs total cost
Direct materials $40,000 $30,000 $70,000 driver units
cost
Direct labor $5,000 $20,000 25,000
driver
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing overhead $50,000
cost
SG&A (selling, general & admin) 30,000 pool
Profit $20,000

Allocate the capacity costs (fixed costs) between Standard and Deluxe.
Use direct labor dollars (DL$) as the cost driver.

allocation rate = (50,000+30,000)/25,000=$3.2 per DL$

allocated costs for Standard = 3.2*5,000=$16,000

allocated costs for Deluxe = 3.2*20,000=$64,000
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 (continued) Try a Different Cost Driver
Standard Deluxe Total
cost Sales volume (in units) 200 100 300
driver Revenue $120,000 $100,000 $220,000
total cost
Variable Costs
driver units
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing overhead $50,000 cost
SG&A (selling, general & admin) 30,000 pool
Profit $20,000
Next, use the number of units as an alternative cost driver. Compute the
allocated costs.

allocation rate = ($50,000+$30,000) / 300 units = $266.67 per unit

allocated costs for Standard = $266.67 per unit × 200 units = $53,333
allocated costs for Deluxe = $266.67 per unit × 100 units = $26,667
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 (continued)
When cost driver = DL$ When cost driver = #units

Standard $16,000 Standard $53,333

Deluxe $64,000 Deluxe $26,667

Which estimate should we choose?

 $16,000 and $64,000 based on DL$?
 $53,333 and $26,667 based on #units?
 it depends on…
 which cost driver best reflects the firm’s operations?
 which cost driver is easiest to use?
 which cost driver yields lowest cost estimates?

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 Refining the Allocation:
Multiple cost pools and cost drivers
• To get more accurate estimates
 break down capacity costs into several cost pools
 choose the best cost driver for each pool

• e.g., use separate pools for fixed manufacturing overhead and

fixed SG&A costs
 DL$ is likely a good cost driver for manufacturing overhead in labor-
intensive manufacturing
 number of units is likely a better cost driver for SG&A costs

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 Example: Multiple cost pools and cost drivers
Standard Deluxe Total
cost Sales volume (in units) 200 100 300
driver 2 Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
cost Direct labor $5,000 $20,000 25,000
driver 1 SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
cost pool 1
Manufacturing overhead $50,000
SG&A 30,000 cost pool 2
Profit $20,000
Allocate fixed manufacturing overhead based on DL$ and allocate fixed
SG&A costs based on #units.
Pool 1: Fixed manufacturing overhead Pool 2: Fixed SG&A costs

allocation rate = $50,000/25,000DL$=$2 allocation rate = $30,000/300

per DL$ units=$100 per unit

Standard =2*5,000=$10,000 Standard = 100*200=$20,000

Deluxe = 2*20,000=$40,000 Deluxe = 100*100=$10,000

Total from pools 1 and 2:

Standard = 10,000+20,000=30,000
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Deluxe = 40,000+10,000=50,000
 Single cost pool vs Multiple cost pools

Single cost pool

Standard
Standard
DL$
($3.2/DL$) $16,000
$16,000
Total fixed costs
$80,000 Deluxe
$64,000

Multiple cost pools/drivers

Standard
Standard
pool 1: fixed
fixed DL$ $10,000
$10,000
($2/DL$) +
manuf. overhead + $20,000
$20,000
=
= $30,000
$30,000
$50,000
$50,000
Total fixed costs
$80,000 Units
Deluxe
Deluxe
pool
pool 2:
2: ($100/unit) $40,000
$40,000
fixed SG&A +
+ $10,000
$10,000
$30,000
$30,000 =
= $50,000
$50,000

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 Using Cost Allocations for Decision
Making in the Long Term
“In most companies, 20-30 percent of the business provides
most of the profits, while 30-40 percent of the customers
and products lose money. The key question is how to
identify which is which.”
HBS Working Knowledge for Business Leaders

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 Long-Term Decisions
and Cost Allocations
• To evaluate long-term decisions, we use
profit margin = contribution margin – capacity costs
• Use cost allocation to
(1) divide capacity costs among product lines to determine
profit margins, and
(2) predict how capacity costs and profit margins will change
in various long-term scenarios

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 Computing Profit Margins
RIP Mattress Company Standard Deluxe Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing + SG&A $80,000
Profit $20,000
Compute the profit margins for Standard and Deluxe. Use DL$ as the cost
driver.
First, allocate the fixed costs (computed previously):
• allocation rate = $80,000/(5,000 DL$ + 20,000 DL$) = $3.2 per DL$
• allocated costs: Standard = $3.2 per DL$ * 5,000 DL$ = $16,000
Deluxe = $3.2 per DL$ * 20,000 DL$ = $64,000
Next, profit margin = CM – allocated FC
• Standard = $65,000 - $16,000 = $49,000
• Deluxe = $35,000 - $64,000 = ($29,000)
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 Keep or Drop a Product Line in the Long Term?
RIP Mattress Company Standard Deluxe Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing + SG&A 16,000 64,000 $80,000
Profit $49,000 ($29,000) $20,000

Should we drop the Standard line in the long term? Why?

 DROP  KEEP

Should we drop the Deluxe line in the long term? Why?

 DROP  KEEP

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 Long-Term vs Short-Term Analysis
Standard Deluxe Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing + SG&A 16,000 64,000 $80,000
Profit $49,000 ($29,000) $20,000

Should we drop the Deluxe line in the long term? Why?

 DROP  KEEP
PM is negative. If you drop Deluxe, profit will increase by $29,000:
you give up $35,000 in CM but save $64,000 in FC.

Should we drop the Deluxe line in the short term? Why?

 DROP  KEEP
CM is positive. If you drop Deluxe, profit will decrease by $35,000:
you give up $35,000 in CM and save NOTHING in FC.
(FC does not change in the short term)
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 Additional Exercises

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 Exercise: Cost Allocation
Basic Premium Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing + SG&A $50,000
Profit $50,000

Use DL$ as the cost driver. Compute allocated capacity costs (fixed
costs) and profit margins for Basic and Premium.
allocation rate = 50,000/25,000=$2 per DL$
allocated costs Basic = 2*5,000=$10,000
allocated costs Premium = 2*20,000=$40,000
profit margin Basic = 65,000-10,000=55,000
profit margin Premium = 35,000-40,000=-$5,000

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 Exercise: Keep or Drop a Product Line?
Basic Premium Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing + SG&A 10,000 40,000 $50,000
Profit 55,000 (5,000) $50,000

Should we drop Premium in the short term? Why?

 DROP  KEEP

If we drop Premium in the short term:

total FC will total profit will
 remain the same  decrease by $35,000
 decrease by $5,000  decrease by $5,000
 decrease by $40,000  increase by $5,000

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 (continued): Keep or Drop a Product Line?
Basic Premium Total
Sales volume (in units) 200 100 300
Revenue $120,000 $100,000 $220,000
Variable Costs
Direct materials $40,000 $30,000 $70,000
Direct labor $5,000 $20,000 25,000
SG&A (selling, general & admin) $10,000 $15,000 25,000
Contribution margin $65,000 $35,000 $100,000
Fixed Costs
Manufacturing + SG&A 10,000 40,000 $50,000
Profit 55,000 (5,000) $50,000

Should we drop Premium in the long term? Why?

 DROP  KEEP

If we drop Premium in the long term:

total FC will total profit will
 remain the same  decrease by $35,000
 decrease by $5,000  decrease by $5,000
 decrease by $40,000  increase by $5,000

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 Exercise: Which Cost Driver Should We Use?
Intel Corporation uses sophisticated equipment to make its computer chips.
It employs a large number of skilled technicians and supervisors to maintain
and monitor the equipment. The production process is 100% automated.

Choose the best cost driver for

Intel’s fixed overhead costs:
 direct labor hours
 number of units produced
 machine hours
 number of assembly workers

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 Exercise: Which Cost Driver Should We Use?

Choose the best cost driver for fixed overhead costs:

 direct labor hours
 number of units produced
 machine hours
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 number of assembly workers